Study Text: Financial Reporting

Financial Reporting
Study Text
The Institute of Chartered

Accountants of Nigeria
© Emile Woolf International ii The Institute of Chartered Accountants of Nigeria
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© Emile Woolf International ii The Institute of Chartered Accountants of Nigeria

C
Skills level
Page
Syllabus v
Chapter
1 Regulatory framework 1
2 Accounting and reporting concepts, frameworks and practices 27
3 Presentation of financial statements 59
4 IAS 8: Accounting policies, changes in accounting estimates and
errors 95
5 IFRS 15: Revenue from contracts with customers 111
6 IAS2: Inventories 149
7 IAS 16: Property, plant and equipment 173
8 Non-current assets: sundry standards
(IAS 23, IAS 20 and IAS 40) 225
9 IAS 38:Intangible assets 249
10 IAS 36: Impairment of assets 275
11 IFRS 5: Non-current assets held for sale and discontinued
operations 289
12 IFRS16: Leases 309
13 IAS 37: Provisions, contingent liabilities and contingent assets 335
14 IAS 12: Income taxes 365
15 IFRS 13: Fair value measurement 403
16 IFRS 9: Financial instruments: Recognition and measurement 421
17 IAS 32 and IFRS 7: Financial instruments: Presentation and
disclosure 457
© Emile Woolf International iii The Institute of Chartered Accountants of Nigeria

Financial reporting
Page
18 Consolidated accounts: Statements of financial position – Basic
approach 473
19 Consolidated accounts: Statements of financial position –
Complications 517
20 Consolidated accounts: Statements of comprehensive income 547
21 Associates and joint ventures 563
22 Sundry standards 579
23 IAS 7: Statement of cash flows 591
24 IAS 33: Earnings per share 647
25 Analysis and interpretation of financial statements 679
26 Ethics and current developments 719
Index 735
© Emile Woolf International iv The Institute of Chartered Accountants of Nigeria

Skills level
SKILLS LEVEL
Aim
Financial accounting from the Foundation level is taken up a notch to financial reporting in
the context of more complex events and transactions with a greater emphasis on
compliance with regulations including international accounting standards and generally
accepted accounting principles.
Candidates will be expected to demonstrate an understanding of and competence in
financial statements preparation, analysis, interpretation and reporting.
Linkage with other subjects

This diagram depicts the relationship between this subject and other
subjects. Financial accounting is a pre-requisite to this subject.
Corporate Reporting
Financial Reporting
Taxation Financial Accounting Business

Law
© Emile Woolf International v The Institute of Chartered Accountants of Nigeria

Financial reporting
Main competencies
On successful completion of this paper, candidates should be able to:
 Explain the importance of regulatory frameworks for accounting and reporting;
 Identify and state the circumstances in which private sector entities are required to
prepare and present statutory financial statements;
 Identify and state the laws, regulations, accounting standards and other requirements
that govern the preparation of financial statements by public and private sector
entities;
 Account for specific transactions in accordance with relevant international accounting
standards;
 Draft and present financial statements, or extract from them, of an entity and simple
groups in accordance with its chosen policies and in accordance with International
Financial Reporting Standards (IFRS) and local laws;
 Assess the circumstances in which the use of IFRS may not be required for
companies;
 Analyse and interpret financial statements of an entities and simple groups; and
 Understand recent developments and ethical issues in the area of financial reporting.
Linkage of the main competencies

This diagram illustrates the linkage between the main competencies
of this subject and is to assist candidates in studying for the
examination.
Explain accounting and
reporting concepts,
frameworks and practice
Account for Understand

Analyse recent
transactions in financial
and developments
statements of public
interpret in financial
and private sector
financial reporting
entities financial
Prepare
statements
statements of private
and public entities
Ethical considerations
in financial reporting
Syllabus overview
Grid Weighting
A Conceptual and regulatory frameworks for financial reporting 10
B Accounting standards and policies relating to specific transactions
in financial statements 20
C Preparation and presentation of general-purpose financial
statements 20
D Preparing and presenting financial statements of simple group
(parent, one subsidiary and an associate) 25
E Analysis and interpretation of financial statements 20
F Ethics and current developments in financial reporting 5
Total 100
© Emile Woolf International vi The Institute of Chartered Accountants of Nigeria

Syllabus
Detailed syllabus Chapt

er
A Conceptual and regulatory framework for financial reporting
1 Conceptual Framework
a Explain the meaning and purpose of conceptual framework. 2
b Explain the objectives, qualitative characteristics and limitations of
financial statements. 2
c Discuss the underlying assumptions in preparing financial
statements. 2
d Identify users of financial statements and their information needs. 2
e Identify and discuss the components of financial statements. 2
f Explain the concept of capital maintenance 2
g Differentiate between principle-based and rule-based financial
reporting frameworks. 1
h Discuss accrual, cash and breakup bases of accounting. 2
2 Regulatory framework
a Discuss the need for a regulatory framework in financial reporting.
1
b Identify and discuss laws, regulations, accounting standards and
other requirements that govern the preparation of financial 1
statements.
c Identify and discuss relevant provisions of Companies and Allied

Matters Act 2020, and special pronouncements by regulatory
authorities (CBN, NDIC, FRCN, NAICOM, NSE, SEC, PENCOM, 1
etc.).
d Explain the standard setting process of International Accounting

Standards Board (IASB) and the relationship with national 1
standard setters.
e Discuss the process for revision of standards.
1
f Discuss the process of adoption of IFRSs and application of local
standards.
g Explain the peculiar nature and relevant frameworks of specialized,

not-for-profit and public sector entities including IFRS, national
standards and International Public Sector Accounting Standards
(IPSAS).
© Emile Woolf International vii The Institute of Chartered Accountants of Nigeria

Financial reporting
Detailed syllabus Chapter

Accounting standards and policies relating to specific transactions
B
in financial statements
1 Tangible non-current assets (IAS 16)
Calculate, where necessary, discuss and account for tangible non- 7, 8
current assets in accordance with the provisions of relevant
accounting standards (IAS 16, IAS 20, IAS 23, IAS 40, and IFRS 5).
2 Intangible non-current assets (IAS 38)
Calculate, where necessary, discuss and account for intangible non- 9
current assets in accordance with the provisions of IAS 38.
3 Impairment of tangible and non-intangible assets (IAS 36)
Calculate, where necessary, discuss and account for impairment of 10
tangible and intangible non-current assets in accordance with the
provisions of IAS 36.
4 Fair value measurement, financial assets and liabilities
a Differentiate between debt and equity financial instruments. 16, 17
b Calculate, where necessary, discuss and account for fair value 15 to 17
measurement of financial assets and liabilities in accordance with
the provisions of relevant accounting standards (IAS 32, IFRS 7
and IFRS 9 and IFRS 13) with respect to measurement,
recognition, de-recognition and disclosures, excluding hedging but
including simple impairment cases.
5 Inventories and revenue from contracts (IAS 2, IFRS 15)
Calculate where necessary, discuss and account for inventories and 5 and, 6
revenue from contracts in accordance with the provisions of relevant
accounting standards (IAS 2 and IFRS 15).
6 Provisions, contingent liabilities and contingent assets and
events after the reporting period (IAS 37 and IAS 10)
Calculate, where necessary, discuss and account for provisions, 13, 22
contingent liabilities and assets as well as events after the reporting
period in accordance with the provisions of relevant accounting
standards (IAS 37 and IAS 10).
7 Income taxes (IAS 12)
Calculate (where necessary), discuss and account for income tax 14
including current and deferred tax in accordance with the provisions of
IAS 12.
8 Earnings per share (IAS 33)
Calculate, discuss and account for earnings per share (EPS) in 24
accordance with the provisions of IAS 33.
© Emile Woolf International viii The Institute of Chartered Accountants of Nigeria

Syllabus

C Preparation and presentation of general purpose financial statements
1 Preparation of financial statements
a Discuss accounting policies and changes in accounting policies in 4
accordance with the provisions of IAS 8 – Accounting policies,
changes in accounting estimates and errors including calculation,
where necessary.
b Prepare and present general purpose financial statements 3
including statement of financial position, statement of profit or loss
and other comprehensive income, statement of changes in equity
and relevant notes in accordance with IAS 1 – Presentation of
financial statements.
c Prepare and present statement of cash flows for single entities in 23
accordance with IAS 7 using direct and indirect methods.
(parent, one subsidiary and an associate)
1 Understanding a simple group
a Explain the concept of group especially a simple group and the 18
objectives of preparing group financial statements.
b Discuss the provisions of the relevant accounting standards for 18 to 21
the preparation and presentation of financial statements of simple
group IAS 28, IFRS 3 and IFRS 10), including the use of fair
value for non-controlling interest.
c Calculate non-controlling interest using alternative methods and 18
effect necessary adjustments required to prepare the financial
statements of simple group.
2 Preparation and presentation
a Prepare and present statement of financial position of a simple 3 and 18
group (one subsidiary and an associate) in accordance with the to 21
provisions of relevant standards (IAS 1, IAS 28, IFRS 3
and IFRS 10).
b Prepare and present statement of profit or loss and other 3 and 20
comprehensive income of a simple group (one subsidiary and an
associate), in accordance with the provisions of relevant
standards (IAS 1, IAS 28, IFRS 3 and IFRS 10).
c Prepare and present statement of cash flows of a simple group 23
(one subsidiary and an associate), in accordance with the
© Emile Woolf International ix The Institute of Chartered Accountants of Nigeria

Financial reporting

E Analysis and interpretation of financial statements
1 Understanding various types of analyses that financial
statements may be subjected to and ratios used in the analysis
a Identify and discuss types of analyses and interpretation of 25
b Discuss various aspects of financial position and performance that 25
may be assessed (profitability, liquidity/solvency, gearing,
investors’ returns) through the analyses and interpretation of
c Define ratio, identify and calculate various types of ratios used in 25
the assessment of financial position and performance of a
business entity.
d Analyse and interpret computed ratios and assess the current 25
period financial position and performance of a business entity in
comparison to:
i its prior period; 25
ii another given entity for the same period; and 25
iii industry average for the same period. 25
e Analyse and interpret computed ratios and assess the current 25
period financial position and performance of a simple group (one
subsidiary and associate) in comparison to:
i its prior period, 25
ii another given simple group entity for the same period and 25
iii industry average for the same period. 25
f Discuss the use of statement of cash flows in assessing liquidity 25
and compare its usefulness with that of a statement of profit or
loss and other comprehensive income when assessing liquidity
and going concern of a business entity.
g Explain the use of earnings per share (EPS) in assessing the 24, 25
performance of corporate entities in the capital market, especially
capital market reaction to earnings announcement.
h Where necessary, write reports as may be required when 25
analysing and interpreting the financial position and performance
of a business entity and simple group, drawing conclusions,
making recommendations and giving advice from the perspectives
of different stakeholders.
© Emile Woolf International x The Institute of Chartered Accountants of Nigeria

Syllabus

E Analysis and interpretation of financial statements (continued)
2 Limitations of analyses and interpretation of financial statements
a Discuss the limitations of historic financial information in the 25
analyses and interpretation of financial statements.
b Explain how financial statements may be manipulated and 25
discuss the impact of window dressing and creative accounting
on calculated ratios and how they can distort analyses and
interpretation of financial statements.
c Explain how analyses and interpretation of financial statements of 25
specialized and not-for-profit organizations differ from those of
profit-oriented organisations.
d Explain why earnings per share (EPS) trend may be a better 25
indicator of performance when compared with a company’s profit
trend and discuss the limitations of using EPS as a performance
measure.
e Explain why and how the use of consolidated financial statements 25
might limit analyses and the use of interpretation techniques.
f Discuss the use of other information, including non-financial 25
information relevant to the assessment of an entity’s performance.
F Ethics and current developments in financial reporting
1 Discuss and apply ethical issues in financial reporting. 26
2 Discuss developments around the inclusion of non-financial 26
information in financial reporting.
3 Discuss new accounting standards in issue as may be specified from na
time to time.
© Emile Woolf International xi The Institute of Chartered Accountants of Nigeria

Financial reporting
Applicable accounting standards Chapter

Preface to IFRS 1
Conceptual framework for financial reporting 2
IAS 1: Presentation of financial statements 3
IAS 2: Inventories 6
IAS 7: Statement of cash flows 23
IAS 8: Accounting policies, changes in accounting estimates and errors 4
IAS 10: Events after the reporting period 22
IAS 12: Income taxes 14
IAS 16: Property, plant and equipment 7
IAS 20: Accounting for government grants and disclosure of government 8
assistance
IAS 23: Borrowing costs 8
IAS 24: Related party disclosures 22
IAS 28: Investments in associates and joint ventures 21

IAS 32: Financial instruments: Presentation 17
IAS 33: Earnings per share 24
IAS 36: Impairment of assets 10
IAS 37: Provisions, contingent liabilities and contingent assets 13
IAS 38: Intangible assets 9
IAS 40: Investment property 8
IFRS 3: Business combinations 18
IFRS 5: Non-current assets held for sale and discontinued operations 11
IFRS 7: Financial Instruments: Disclosures 17
IFRS 9: Financial instruments 16
IFRS 10: Consolidated financial statements 17-19
IFRS 13: Fair value measurement 15
IFRS 15: Revenue from contracts with customers 5
IFRS 16: Leases 12
© Emile Woolf International xii The Institute of Chartered Accountants of Nigeria

CHAPTER
Contents
The regulatory framework
The IFRS Foundation and the IASB
Accounting standards in Nigeria
Legal regulations for Accounting in Nigeria
Regulatory frameworks for public sector and not-for- profit organisations
Chapter review
© Emile Woolf International 1 The Institute of Chartered Accountants of Nigeria

Financial reporting
INTRODUCTION
Aim
the context of more complex events and transactions with a greater emphasis on compliance
with regulations including international accounting standards and generally accepted
accounting principles.
Candidates will be expected to demonstrate an understanding of and competence in financial
statements preparation, analysis, interpretation and reporting.
Detailed syllabus
The detailed syllabus includes the following:
2 Regulatory framework
a Discuss the need for a regulatory framework in financial reporting.
b Identify and discuss laws, regulations, accounting standards and otherrequirements

that govern the preparation of financial statements.
c Identify and discuss relevant provisions of Companies and Allied Matters Act 2020,
and special pronouncements by regulatory authorities (CBN, NDIC, FRCN, NAICOM,
NSE, SEC, PENCOM, etc.).
d Explain the standard setting process of International Accounting Standards Board

(IASB) and the relationship with national standard setters.
e Discuss the process for revision of standards.
f Discuss the process of adoption of IFRSs and application of local standards.

g Explain the peculiar nature and relevant frameworks of specialised, not-for-profit and
public sector entities including IFRS, national standards and International Public
Sector Accounting Standards (IPSAS).
Exam context
This chapter explains aspects of the Nigerian regulatory framework for financial reporting
By the end of this chapter, you will be able to:

Explain the sources of accounting regulation in Nigeria
Outline the roadmap for conversion to IFRS in Nigeria

Understand the rules on financial statements set out in Companies and Allied Matters Act 2020
Explain the standard setting process for IFRS
„ Explain how financial statements of public sector entities and not-for-profit entities
might differ from those of private sector, profit making entities.

Chapter 1: Regulatory framework
1 THE REGULATORY FRAMEWORK
The need for regulation

Sources of regulation
Principles and rules
1.1 The need for regulation

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.
There are several reasons why financial reporting should be regulated. The most
obvious one is that without it, an entity would be free to adopt any accounting
treatment that it chose.
Other reasons are as follows:
‰ People external to businesses are normally dependent on the published financial
statements for information about an entity’s activities. Regulation ensures that
external users of financial statements are provided with information that is
relevant to their decisions and reliable.
‰ Accounting standards and other forms of regulation help to ensure that entities
adopt similar accounting treatments for similar items and account for similar
transactions in the same way. This makes it possible to compare the financial
statements of different entities and to compare an entity’s performance for the
current year with its performance in previous years.
‰ Without regulation, management would adopt whichever accounting treatment
that presents its results and position in the best possible light. Sometimes,
management might deliberately mislead users of the financial statements.
1.2 Sources of regulation

The main sources of regulation are:
‰ Accounting standards;
‰ Company law;
‰ Sectoral regulations; and
‰ The listing rules of the relevant Stock Exchange, for listed companies,
Accounting standards are authoritative statements of how particular types of
transactions and events are reflected in the financial statements. International
Financial Reporting Standards are used in Nigeria.
Company law varies from country to country, but typically also it sets out rules
for determining profits available for distribution, issuing and redeeming share
capital, the reserves that a company must have and the uses to which they can
be put. These matters are not covered in accounting standards. The main
company law statute in Nigeria is the Companies and Allied Matters Act 2020
Sectoral regulation may apply to certain industries, for example, the banking
sector is regulated by Central Bank of Nigeria, insurance sector y by National
Insurance Commission and pension by Pension Commission. Such regulations
may specify peculiar financial reporting requirements of the sectors. For
3
example, in Nigeria, the Central Bank prudential guidelines override impairment

provision of IFRS 9.
Listing rules set out the information which entities must supply when their shares
are traded on a major stock market. They must comply with these rules in order to
maintain their listing. These rules include requirements relating to information,
including financial reports that entities must prepare and provide to the stock
market while they are listed.
1.3 Principles and rules

Company law consists of detailed rules. Accounting standards may be rules-
based or principles-based. IASs and IFRSs are mainly principles based, though
some would argue that in practice they are a mixture of rules and principles.
It is possible for rules and principles to complement each other. Many countries
(including Nigeria, the UK, Canada and Australia) have a regulatory system in
which company law deals only with a few specific matters. Detailed financial
reporting practice is developed by the accounting profession through accounting
standards. Accounting standards are generally (though not always) principles-
based. This allows reporting practice to develop over time in response to the
needs of users and changes in the business environment. Accounting standards
usually allow preparers to exercise judgement in developing accounting policies
that are appropriate to the circumstances of a particular entity.
In other countries the content of financial statements and accounting practice may
be prescribed in great detail by company law with little scope for individual
judgement. Because the existing framework is based on detailed rules, users of
the financial statements tend to view principles-based accounting as insufficiently
rigorous.
2 THE IFRS FOUNDATION AND THE IASB
Background
The standard setting structure
IFRSs and IASs
Developing a new standard
2.1 Background
The International Accounting Standards Committee (IASC) was established in
1973 to develop international accounting standards with the aim of harmonising
accounting procedures throughout the world.
The first International Accounting Standards (IASs) were issued in 1975. The
work of the IASC was supported by another body called the Standing
Interpretation Committee. This body issued interpretations of rules in standards
when there was divergence in practice. These interpretations were called
Standing Interpretation Committee Pronouncements or SICs.
In 2001 a new standard setting structure was introduced headed up by the IASC
Foundation (“the foundation”). The foundation is now called the IFRS Foundation.
4
2.2 The standard setting structure
The current structure of the organisations responsible for publishing international
accounting standards is as follows:
Illustration: Standard setting structure
The IFRS Foundation

The foundation, a not-for-profit organisation is run by 22 trustees who are
responsible for:
▪ the governance of the Foundation and the bodies within it; and
▪ fund-raising
The constitution of the Foundation includes a requirement that, in order to achieve a

broad international basis, there must be:
• 6 trustees from the Asia/Oceania region;
• 6 trustees from Europe;
• 6 trustees from the Americas;
• 1 trustee from Africa; and
• 3 trustees who may be appointed form any area.
The International Accounting Standards Board (IASB)

The International Accounting Standards Board (IASB) is the standard-setting
body of the IFRS Foundation.
The IASB is responsible for developing international accounting standards. It has
full responsibility for all IASB technical matters, including the issue of IFRSs and
revised IASs, and has full discretion over the technical agenda of the IASB.
The objectives of the IASB are to:
• develop, in the public interest, a single set of high-quality global accounting
standards;
• promote the use and rigorous application of those standards;
• to take account of the special needs of small and medium sized entities and
emerging economies; and
• to promote and facilitate the adoption of IFRS through the convergence
of national accounting standards and the international accounting
standards.
5
Financial reporting
The IASB consists of 14 members, all with a very high level of technical expertise
in accounting, are appointed by the trustees of the IFRS Foundation. Each IASB
member is appointed for a five-year term, which might be renewed once for a
further five years.
Each IASB member has one vote, and approval of nine members is required for
the publication of:
• an exposure draft
• a revised International Accounting Standard (IAS)
• an International Financial Reporting Standard (IFRS)
• a final Interpretation of the IFRS Interpretations Committee (IFRSIC).
The IFRS Interpretations Committee (IFRSIC)

The role of IFRSIC is to issue rapid guidance where there are differing possible
interpretations of an international accounting standard. Its role is therefore to:
• interpret international accounting standards (IASs and IFRSs);
• issue timely guidance on issues not covered by an IAS or IFRS, within the
context of the IASB Conceptual Framework; and
• publish draft Interpretations for public comment. After studying responses
to the draft Interpretation, it will obtain IASB approval for a final (published)
Interpretation (anIFRIC)
The IFRS Advisory Council (IFRSAC)

The IFRS Advisory Council (IFRSAC) provides a forum through which the IASB is able
to gather opinions and advice from different countries and industries. The IFRSAC
consists of experts from different countries and different business sectors, who offer
advice to the IASB.
2.3 IFRSs andIASs

Following the establishment of the IFRS Foundation in 2001, the IASB became
the body responsible for:
• developing and publishing accounting standards as IFRSs; and
• approving and publishing Interpretations of IFRSs.
Previously, standards had been published as International Accounting Standards

(IASs) and Interpretations were published as SIC Interpretations.
The IASB adopted all IASs and SICs that were extant at the time but said that
standards written from that time were to be called International Financial
Reporting Standards (IFRS). Interpretations are known as IFRICs.
The term IFRS is also used to refer to the whole body of rules (i.e., IAS and IFRS
in total).
6
Thus IFRS is made up as follows:
Published bythe IASC Published by the IASB

(upto 2001) (from2001)
Accountingstandards IASs IFRSs
Interpretations SICs IFRICs
Note that many IASs and SICs have been replaced or amended by the IASB
since 2001.
Note that interpretations are not examinable at this level.
The following pages set out a list of standards so that the breadth of the GAAP
can be appreciated. Not all of these standards are examinable at this level. Those
that are examinable are indicated on the list. Please note that many of the
standards examinable at this level will also be examinable in more detail in
Corporate Reporting.
Applicable in Examinable at
Standard
Nigeria? This level?
IAS 1 – Presentation of Financial Yes Yes
Statements
IAS 2 – Inventories Yes Yes
IAS 7 – Cash Flow Statements Yes Yes
IAS 8 – Accounting Policies,
Changes in Accounting
Estimates and Errors Yes Yes
IAS 10 – Events occurring after the
reporting period Yes Yes
IAS 11 – Construction Contracts Yes Yes
7
Standard
Nigeria? this level?
IAS12 – Income Taxes Yes Yes (inpart)

IAS16 – Property, Plant and Yes Yes
Equipment
IAS 19 – Employee Benefits Yes No

IAS 20 – Accounting for Government
Grants and Disclosure of
Government Assistance Yes Yes
IAS 21 – The Effects of Changes in
Foreign Exchange Rates Yes No
IAS 23 – Borrowing Costs Yes Yes
IAS 24 – Related Party Disclosures Yes Yes
IAS 26 – Accounting and Reporting
by Retirement Benefit Plans Yes No
IAS 28 – Accounting for Investments
in Associates and Joint
ventures Yes Yes
IAS 29 – Financial Reporting in Not relevant in
Hyperinflationary Economies Nigeria No
IAS 32 – Financial Instruments:
Presentation Yes Yes
IAS 33 – Earnings Per Share Yes Yes
IAS 34 – Interim Financial Reporting Yes No
IAS 36 – Impairment of Assets Yes Yes
IAS 37 – Provisions, Contingent
Liabilities and Contingent
Assets Yes Yes
IAS 38 – Intangible Assets Yes Yes
IAS 40 – Investment Property Yes Yes
IAS 41 – Agriculture Yes No
IFRS 1 – First time adoption of IFRS Yes (subject to
specific guidance
issued by FRCN) No
IFRS 2 – Share-based payment Yes No
IFRS 3 – Business combinations Yes Yes
IFRS 5 – Non-current assets held for
sale and discontinued
operations Yes Yes
IFRS 6 – Exploration for and
evaluation of mineral
resources Yes No
8
Standard
Nigeria? this level?
IFRS7 – Financial Instruments: Yes Yes
Disclosures

IFRS 8 – Operating segments Yes No
IFRS 9 – Financial Instruments Yes Yes
IFRS 10 – Consolidated financial
statements Yes Yes
IFRS 11 – Joint arrangements Yes No
IFRS 12 – Disclosure of interests in Yes
other entities No
IFRS 13 – Fair value measurement Yes Yes
IFRS 14 – Regulatory deferral accounts Yes No
IFRS 15 – Revenue from contracts with Yes
customers Yes
IFRS 16 – Leases Yes Yes
IFRS 17 – Insurance contracts Yes No
IFRS for SMEs Yes No
2.4 Developing a newstandard

IFRSs are developed through international due process. Due process normally
(but not necessarily) involves the following steps.
‰
‰ A subject is identified as being appropriate for a new or revised standard.
‰ National accounting rules and practice are studied and there is an exchange of
views with national standards setters (e.g. The Financial Reporting Council of
Nigeria the role of which is covered in more detail later in this chapter).
‰ An advisory group is established to give advice to the IASB.
‰ A discussion document is issued by the IASB for public comment.
‰ After receiving comments on the discussion document, the IASB issues an
Exposure Draft (subject to the appropriate level of IASB approval). The Exposure
Draft also includes the opinions of any dissenting IASB members, and the basis for
the IASB’s conclusions.
‰ All comments on the Exposure Draft and discussion documents are
considered. Includes consideration of
x whether it is desirable to hold a public hearing;
x whether it is desirable to hold field tests
x whether it is necessary to issue a revised ED (when the deliberations
following the original ED indicate that there is a need for substantial changes from
what was originally envisaged).
‰ An approved IFRS is published (subject to the appropriate level of IASB
approval). This will also include the opinions of any dissenting IASB members,
and the basis for the IASB’s conclusions. Each new or revised standard is
published with a date for implementation and guidance on how an entity should
account for the transition to the new accounting rules.
The development of a new or revised accounting standard involves widespread

consultation and discussion.
Any new standard published by the IASB is automatically applicable in Nigeria.

Financial reporting
3 ACCOUNTING STANDARDS IN NIGERIA
Background to accounting standards in Nigeria (NASB)

Financial Reporting Council of Nigeria (FRCN)
Adoption of IFRS in Nigeria
Advantages and disadvantages of convergence with IFRS
National standard setters and the IASB
3.1 Background to accounting standards in Nigeria (NASB)

The Nigerian Accounting Standards Board (NASB) which came into being in 1982
was an independent body which was previously responsible for the development
and issuance of Nigerian accounting standards. These were called Statements
of Accounting Standards.
The standards were given legal authority in Nigeria by section 335 of the
Companies and Allied Matters Act 1990. This section required that “financial
statements….shall comply. ... with the accounting standards laid down in the
Statements of Accounting Standards issued from time to time by the Nigerian
Accounting Standards Board to be constituted by the Minister .... "
The Nigerian Accounting Standards Board was formally established as a
parastatal in 1992.
Definition: Parastatal
Noun: A company or agency owned or controlled wholly or partly by the
government
Adjective: Of an organization or industry, having some political authority and
serving the state indirectly (e.g., a parastatal organisation).
The Nigerian Accounting Standards Board Act No. 22, 2003 clarified the status,
authority and responsibilities of the board.
3.2 Financial Reporting Council of Nigeria (FRCN)

In June 2011, Financial Reporting Council of Nigeria Act, No. 6, 2011 repealed
the Nigerian Accounting Standards Board Act No. 22, 2003. This Act resulted
in the Nigerian Accounting Standards Board being replaced by the Financial
Reporting Council of Nigeria (FRCN).
The Financial Reporting Council of Nigeria is a federal government parastatal
under the supervision of the Federal Ministry of Industry, Trade and Investment.
The FRCN’s main objects, as defined in the FRC Act, are:

• To protect investors and other stakeholder’s interest;
• To give guidance on issues relating to financial reporting and corporate
governance to professional, institutional and regulatory bodies in Nigeria;
• To ensure good corporate governance practices in the public and private
sectors of the Nigerian economy;
Financial reporting
• To ensure accuracy and reliability of financial reports and corporate

disclosures, pursuant to the various laws and regulations currently in
existence in Nigeria;
• To harmonise activities of relevant professional and regulatory bodies as
relating to corporate governance and financial reporting;
• To promote the highest standards among auditors and other professionals
engaged in the financial reporting process;
• To enhance the credibility of financial reporting; and
• To improve the quality of accountancy and audit services, actuarial,
valuation and corporate governance standards.
The FRCN is structured into a series of directorates to allow it to fulfil its many
responsibilities. The directorates are:
• Directorate of Accounting Standards – Private Sector
• Directorate of Accounting Standards – Public Sector
• Directorate of Auditing Practice Standards
• Directorate of Actuarial Standards
• Directorate of Valuation Standards
• Directorate of Inspection and Monitoring
• Directorate of Corporate Governance
Directorate of Accounting Standards – Private Sector

The FRCN is responsible for, among other things, developing and publishing
accounting and financial reporting standards to be applied in the preparation of
financial statements of public entities in Nigeria; and for related matters.
To this end the Directorate of Accounting Standards has the following
responsibilities:
• To develop accounting and financial reporting standards to be observed
in the preparation of financial statements in the private sector and small
and medium scale enterprises;
• To promote the general acceptance and adoption of such standards
by preparers and users of financial statements;
• To promote compliance with the accounting standards
developed or reviewed by the Directorate;
• To review from time to time the accounting standards developed in line with
the prevalent social, economic and political environment;
• To promote compliance with the accounting and financial reporting
standards adopted by the Council;
• To promote, in the public interest, accounting and financial reporting
standards to be observed in the preparation of financial statements
of public interest entities; and
• To perform such other duties which in the opinion of the Board are
necessary or expedient to ensure the efficient performance of the functions
of the Council.

3.3 Adoption of IFRS in Nigeria

IFRS cannot be applied in any country without the approval of the national
regulators in that country. All jurisdictions have some kind of formal approval
process which is followed before IFRS can be applied in that jurisdiction. In
Nigeria, however, the FRCN has not published any formal procedure for
adoption of IFRS, but appears to follow IASB prescription on when a new
standard comes into force. The implication is that a new IFRS becomes
applicable in Nigeria on the effective date prescribed by IASB. As such, it
does not permit early adoption.
The FRCN oversaw the convergence of Nigerian GAAP to IFRS through a plan
(known as a roadmap) which set out the route to conversion. This roadmap was
structured as several phases with each phase requiring certain categories of
companies to comply with IFRS by a given date.
Phase 1: Significant public interest entities and publicly listed entities

Entities in this category include:
‰ Government business entities
‰ Entities that have equity or debt instruments listed and traded in domestic
markets, foreign markets or in over the counter trades.
‰ All other organisations which are required by law to file returns with
regulatory authorities (this excludes private companies that routinely file
returns only with the Corporate Affairs Commission and Federal Inland
Revenue Service). This category will include private entities involved in
financial services.
‰ All entities in this category adopted IFRS in 2012.
Phase 2: All other public interest entities

These are unquoted private companies which are of significant public interest
because of the nature of their business, size, number of employees, etc.
All entities in this category adopted IFRS in 2013.
Phase 3: Small and medium - sized entities (SMEs)
The following are the characteristics of SMEs:
▪ They are not public interest entities: They are required to apply the IFRS for
SMEs’;SMEs are entities that may not have public accountability;
▪ Their equity and debt instruments are not traded or in the process
of becoming traded;
▪ They do not hold assets in a fiduciary capacity for a broad group
ofoutsiders as one of their primary businesses;
▪ Their annual turnover (revenue) is not more than ₦120 million or such
amount as might be fixed by the Corporate Affairs Commission as
prescribed by section 394 (3) CAMA 2020;
▪ Their total assets value is not more than ₦60 million or such amount as
might be fixed by the Corporate Affairs Commission.
▪ They do not have foreign board members;
▪ No member of the entity is a government, government agency,
government corporation or a nominee of any such body;

▪ The directors hold not less than 51% of its equity share capital; and
▪ Micro-sized entities, which may use either the IFRS for SMEs or the Small
and Medium-sized Entities Guidelines on Accounting (SMEGA) Level 3
issued by the United Nations Conference on Trade and Development
(UNCTAD). Micro-sized entities are entities that are not public interest
entities or SMEs.
Comment on Nigerian Accounting Standards

Nigerian accounting standards have been replaced by International Financial
Reporting Standards.
However, Nigerian standards included industry specific rules which are not found
in IFRS. Companies in the industries covered are expected to continue to apply
these rules (insofar as they do not conflict with IFRS). Such relevant standards
include:
‰ SAS 14: Accounting in the petroleum industry: Down-stream activities
‰ SAS 17: Accounting in the petroleum industry: Up-stream activities
‰ SAS 25: Telecommunications activities)
‰ SAS 32: On accounting by not-for-profit organisations.
3.4 Advantages and disadvantages of convergence with IFRS
Advantages
Investors and analysts of financial statements can make better comparisons
between the financial position, financial performance and financial prospects of
entities in different countries. This is very important, in view of the rapid growth in
international investment by institutional investors.
For international groups, harmonisation will simplify the preparation of group
accounts. If all entities in the group share the same accounting framework, there
should be no need to make adjustments for consolidation purposes.
If all entities are using the same framework for financial reporting, management
should find it easier to monitor performance within their group.
Global harmonisation of accounting framework may encourage growth in cross-
border trading, because entities will find it easier to assess the financial position
of customers and suppliers in other countries.
Access to international finance should be easier, because banks and investors in
the international financial markets will find it easier to understand the financial
information presented to them by entities wishing to raise finance.
Disadvantages
National legal requirements may conflict with the requirements of IFRSs. Some
countries may have strict legal rules about preparing financial statements, as the
statements are prepared mainly for tax purposes. Consequently, laws may need
re-writing to permit the accounting policies required by IFRSs.
Cultural differences across the world may mean that one set of accounting
standards will not be flexible enough to meet the needs of all users.
Some countries may believe that their framework is satisfactory or even superior
to IFRSs. This has been a problem with the US who have not adopted IFRS.

3.5 National standard setters and the IASB

National standard setters (like FRCN) traditionally produced accounting standards
for application in their own jurisdiction. However, the acceptance of the benefits of
a global set of accounting standards has caused their role to change in many
jurisdictions.
The IASB works with national standard-setters to promote and facilitate adoption
of IFRSs through convergence of national accounting standards and IFRSs.
The IASB encourages the collaboration of national standard setters in research
programme and standard-setting activities. Specifically, national standard setters
are encouraged to respond to due process documents by providing comment
letters and to undertake research to better understand the effects of proposed
new standards in their jurisdictions.
In addition, national standard setters are well placed to support implementation
by organising local events on the rules.
There are various national and regional forums that national standard setters can
get involved in, some of which are organised by IASB and others organised
independently.
The IFRS Foundation encourages national standard setters to participate in
standard-setting communities organised on a regional basis. One such regional
community is the Pan African Federation of Accountants (PAFA).
Role of national standard setters
National standard setters have a key role to play in the development of standards
and their implementation in the jurisdictions they serve.
The IASB sees the national standard setters as important partners in their work
to produce global accounting standards.
‰ Their knowledge of local financial reporting and legal requirements,
experience in standard-setting and technical accounting capabilities allow
them to make invaluable contribution to the development of global
accounting standards;
‰ Their relationships with key stakeholders in their jurisdictions are important
as they are able to represent them in the international debate on
development of new rules and inform them of the progress of those rules.

Financial reporting
4 LEGAL REGULATIONS FOR ACCOUNTING IN NIGERIA
Companies and Allied Matters Act (CAMA)2020

Section 374: Requirement to keep accounting records
Section 378: Form and content of individual financial statements
Section 383: Disclosure of loans to directors and officers
Section 386: Procedure on completion of financial statements
Section 385: Directors’ reports
4.1 Companies and Allied Matters Act (CAMA)2020

CAMA is the primary source of company law in Nigeria. Amongst other things,
it establishes the requirements for financial reporting by all companies in
Nigeria.
The rules are set out in Chapter 14 of the Act which includes sections 374 to 400.
4.2 Requirement to keep accounting records

Section 374 states that:
‰ Every company shall cause accounting records to be kept.
‰ The accounting records shall be sufficient to show and explain the
transactions of the company and shall be such as to:
a. disclose with reasonable accuracy, at any time, the financial position of the
company; and
b. enable the directors to ensure that financial statements prepared
comply with the requirements of the Act with regard to form and content.
The accounting records must contain:
c. entries from day-to-day of all sums of money received and expended by the
company, and the matters in respect of which the receipts and expenditure
take place, and
d. a record of assets and liabilities of the company.
If the business of the company involves dealing in goods, the accounting records
shall contain:
(a) statements of stock held by the company at the end of each
accounting year of the company;
(b) all statements of stock takings from which any such statement of stock
has been or is to be prepared; and
(c) except in the case of goods sold by way of ordinary retail trade, statement
of all goods sold and purchased, showing the goods and the buyers and
sellers in sufficient detail to enable all these to be identified.

Section 375: Place and duration of records

The accounting records must be kept at the company’s registered office or such
other place in Nigeria as the directors think fit.
They must be open to inspection by the officers of the company at all times.
Accounting records must usually be kept for a period of six years from the date
on which they were made.
Section 377: Directors' duty to prepare annual accounts

In the case of every company, the directors shall, in respect of each year, of the
company, prepare financial statements for the year.
At their first meeting after the incorporation of the company, the directors must
determine the accounting year end for the company.
4.3 Section378: Form and content of individual financial statements Directors

have a duty to prepare annual financial statements each year. These statements
must include:
• a statement of accounting policies;
• a balance sheet (statement of financial position);
• a profit and loss account (statement of comprehensive income);
• notes on the accounts;
• the auditors’ report;
• the directors’ report;
• a value-added statement for the year;
• a five year financial summary; and
‰ in the case of a holding company, the group financial statements.
Section 378 states that financial statements must comply with the requirements
of the first Schedule to the Act with respect to their form and content.
However, the section continued to say that financial statements must also comply
with accounting standards laid down in the Statements of Accounting Standards
issued by the Financial Reporting Council of Nigeria.
Paragraph 59 of the Financial Reporting Council Act of 2011 gives precedence
to the accounting rules in the standards adopted (IFRS) and other rules in the
legal framework if they are inconsistent.
True and fair view

The balance sheet must give a true and fair view of the state of affairs of the
company as at the year end and the profit and loss account must give a true and
fair view of the profit or loss of the company for the year.
The true and fair requirement is of overriding importance:
‰ Additional information must be provided if necessary for the financial
statements to give a true and fair view.

Financial reporting
‰ If, owing to a special circumstance, compliance with an accounting

requirement results in a failure to show a true and fair view, the directors
must depart from that requirement in preparing the balance sheet or profit
and loss account (so far as necessary) in order that the financial statements
achieve a true and fair view. In this case, the following must be disclosed in
a note to the accounts:
(a) particulars of the departure;
(b) the reasons for it; and
(c) its effects.
4.4 Disclosure of loans to directors and officers
Section 383: Disclosure of loans in favour of directors and connected persons

Section 296 sets out a general prohibition on a company from making a loan or
guaranteeing a loan to a director.
CAMA allows the following exceptions to this:
▪ A loan may be made to a director for the purpose of enabling him to
properly perform his duties as an officer of the company but this is
subject to approval at a general meeting; or
▪ A loan may be made or a guarantee given by a company whose ordinary
business includes the lending of money or the giving of guarantees in
connection with loans made by other persons.
If a loan has been made, the following must be disclosed:
▪ the amount of the liability of the person to whom the loan was or was
agreed to be made, in respect of principal and interest, at the beginning
and at the end of the year;
▪ the maximum amount of that liability during that year;
▪ the amount of any interest which, having fallen due, has not been paid; and
▪ the amount of any provision for any failure or anticipated failure by
the borrower to repay the whole or part of the loan or interest.
If a guarantee has been given the following must be disclosed:
▪ the amount for which the company was liable under the guarantee or
in respect of the security both at the beginning and at the end of the
year;
▪ the maximum amount for which the company may become liable; and
▪ any amount paid and any liability incurred by the company for the purpose
of fulfilling the guarantee or discharging the security.
Section 384: Disclosure of loans, etc., to officers

If a company has made a loan or guaranteed a loan to an officer of the company,
it must make the following disclosures:
▪ the aggregate amounts outstanding at the end of the financial year;
▪ the number of officers for whom the transactions, arrangements
and agreements falling within each of those subǦparagraphs, were
made.

▪ The disclosure does not apply if the aggregate amounts outstanding

at the end of the year in respect of any officer do not exceed N5,000 nor
to loans made by a recognized bank to any of its officers.
4.5 Procedure on completion of financial statements
Section 386: Signing of balance sheet and documents to be annexed there to

A company's balance sheet and every copy of it which is laid before the company
in general meeting or delivered to the Commission shall be signed on behalf of the
board by two of the directors of the company.
Section 387: Persons entitled to receive financial statements as of right

A company must send a copy of its financial statements for the year to all of the
following not less than 21 days before the date of the meeting at which they are
to be laid:
▪ every member of the company (whether or not entitled to receive notice
of general meetings);
▪ every holder of the company's debentures, (whether or not so entitled); and
▪ all persons other than members and debenture holders, being persons
so entitled.
Section 388: Directors' duty to lay and deliver financial statements

The directors must lay the financial statements before the company in a general
meeting not later than 18 months after incorporation.
The directors must lay the financial statements before the company in a general
meeting subsequently at least once a year not exceeding nine months after the
year-end.
The directors must deliver with the annual return to the Commission a copy of the
balance sheet, the profit and loss account and the notes on the statements which
were laid before the general meeting for each year.
Section 390: Shareholders' right to obtain copies of financial statements

Any member of a company or any debenture holder is entitled on demand to a
copy of the company's last financial statements.
4.6 Section: 385. Directors' report

Every company must prepare a directors’ report which must contain the following:
▪ a fair view of the development of the business of the company and its
subsidiaries during the year and of their position at the end of it; and
▪ the amount (if any) which the directors recommend should be paid as
dividend and the amount (if any) which they propose to carry to reserves.
▪ the names of the persons who were directors of the company at any time
during the year;
▪ the financial activities of the company and its subsidiaries in the course of
the year and any significant change in those activities in the year;
▪ particulars of significant changes (if any) in the fixed assets of the company
in the financial year;
▪ the difference between the market value land and the amount at which it is
recognised in the statement of financial position if, in directors' opinion, the
difference is of such significance that the attention of members or debenture
holders;
▪ details of directors' interests in the company’s shares and debentures;
▪ particulars of any important events affecting the company which have
occurred since the end of the year;
▪ an indication of likely future developments in the business;
▪ an indication of the activities (if any) of the company in the field of research
and development;
▪ names of distributors of the company's products; and
▪ particulars of donations and gifts made for any purpose.

5 REGULATORY FRAMEWORKS FOR PUBLIC SECTOR AND NOT

FOR PROFIT ORGANISATIONS
Introduction
Private sector and public sector organisations
Not-for-profit entities
5.1 Introduction
This section provides information about the “peculiar nature and relevant
frameworks of specialized, not-for-profit and public sector entities including IFRS,
national standards and IPSAS” as referred to in the syllabus.
There are many different ways in which organisations might be classified. For
example, entities might be classified based on:
▪ Whether they operate in the private sector or the public sector;
▪ Whether they exist to make a profit or are not-for-profit organisations.
Most public sector organisations would also be not-for-profit. However,

sometimes a government might own “for profit” trading entity that for all practical
purposes is just like a private company. For example, a government might own
the electricity supply companies who sell electricity to the public. These are
known as government business enterprises (GBEs). GBEs would normally
prepare financial statements according to IFRS and will not be considered further.
Most private sector organisations would exist to make a profit. However, there
are many who do not, for example, charities.
Another way of putting it is that most profit-making entities exist in the private sector
(but there are some in the public sector) and most not-for-profit entities are in the
public sector but there are some in the private sector.
5.2 Private sector and public sector organisations

The private sector is the part of a nation’s economy which is owned and
controlled by private individuals or organisations. Private sector organisations
include limited companies, partnerships and sole traders.
The public sector is the part of a nation’s economy which is under the control of
government. Public sector entities include national governments, regional
governments (for example, state, provincial, territorial), local governments (for
example, city, town) and their component entities (for example, departments,
agencies).
Financial reporting
Key differences between a private sector company and a public sector
organisation are as follows:
Private sector (Limited Public sector

company) organisation
Ownership Shareholders The people (through the
government)
Management The owners or managers Government appointees
appointed by the owners
Objective To make a profit To provide a service
Funding From shareholders or By grant from the
borrowing from financial government
institutions
In total, the public sector comprises a large number of organisations which

provide a multiplicity of services. Often a single public sector organisation might
have multiple objectives. For example, a government ministry for health might
have objectives in the areas of disease prevention, disease treatment, health
initiatives, health education etc.
In this text the term public sector entity will be used to mean a body that exists to
provide a service to the public at large (government business enterprises will not
be considered further).
All organisations have to be managed to achieve their objectives and to do this
management need information. This information is gathered and processed by
management information systems. The accounting system is a very important
part of any entity’s management information systems.
5.3 Not-for-profit entities

Not-for-profit entities are entities that usually have no transferable ownership
interests, set up and operated exclusively for social, educational, professional,
religious, or charitable purposes for the benefits of the public or its members.
Some such entities (e.g., charities) might operate under a specific statutory
framework that might specify financial reporting rules.
Not-for-profit 25organization differ from profit making entities in key respects and
the financial reporting rules whether imposed by regulation or otherwise should
reflect these differences.
Key differences that need to be reflected in financial reports include the following:
▪ Not-for-profit organisation would seek to operate at a surplus. However,
any surplus arising from their activities are not generally distributed to
owners but are used to pursue the goals andobjectives.
▪ Revenue is earned when an organisation supplies goods and services to
customers. Not-for-profit organisation do not have revenue as such but are
financed by donations, contributions from members, cash raised from the
public etc. Sometimes, donations are made for a restricted purpose and
this must be reflected in the financial statements.

The financial statements of not-for-profit organisation might deal with these

issues as follows:
▪ Financial statements identify the different types of “revenue” received and the
costs of generating this revenue.
▪ Financial statements should refer to surplus rather than profit or deficit
rather than loss and
▪ There is no accumulated profit but there may be an accumulated surplus.
▪ The statement of financial position of not-for-profit organisation might
represent several groups of net assets each held for a specific purpose and
each represented by its own capital balance. These are known as funds.
Net assets 10,000
Represented by:
General fund 7,000
Restricted fund 1 (Educational purposes) 1,000
Restricted fund 2 (Disaster relief) 2,000
10,000
The net assets represented by the general fund can be used for
any of the organisations purposes.
The net assets represented by Restricted fund1can be used only
in pursuit of the organisation’s educational objectives.
The net assets represented by Restricted fund can be used only
for disaster relief.
Restrictions on assets held generally arise because:

they were donated for a specific purpose – e.g., money given to
the organisation26 where the donor specifies how it is to be
used; or
the money was raised for a specific purpose – e.g., money raised
in an appeal in response to a natural disaster.
The Nigerian Accounting Standards Board issued SAS 32: On accounting by

not-for-profit organisation in 2011. This is not an examinable standard at this
level.
Note that the IASB Foundation is a not-for-profit 26organisation that applies IFRS
in its financial statements.

Financial reporting
6 CHAPTER REVIEW
Before moving on to the next chapter check that you now know how to:
Explain the sources of accounting regulation in Nigeria
Outline the roadmap for conversion to IFRS in Nigeria
Understand the rules on financial statements set out in Companies and Allied
Matters Act 2020
Explain the standard setting process for IFRS
Explain how financial statements of public sector entities and not-for-profit entities
might differ from those of private sector, profit making entities.

CHAPTER
Contents
A conceptual framework for financial reporting
The IASB Conceptual Framework
Qualitative characteristics of useful financial
information
The elements of financial statements
Recognition and derecognition
Accounting concepts
Bases of accounting
Measurement and capital maintenance
Fair presentation
Chapter review

Financial reporting
INTRODUCTION
Aim
Financial accounting from the Foundation level is taken up a notch to financial reporting in the
context of more complex events and transactions with a greater emphasis on compliance with
regulations including international accounting standards and generally accepted accounting
principles.
Detailed syllabus
1 Conceptual Framework
a Explain the meaning and purpose of conceptual framework.
B Explain the objectives, qualitative characteristics and limitations of financial
statements.
C Discuss the underlying assumptions in preparing financial statements.
D Identify users of financial statements and their information needs.
E Identify and discuss the components of financial statements.
F Explain the concept of capital maintenance
g Differentiate between principle-based and rule-based financial reporting
frameworks.
H Discuss accrual, cash and breakup bases of accounting.
I Discuss financial statements in relation to reporting entities under the
conceptual framework.
Exam context
This chapter explains each of the above.

„ Explain the objectives of financial statements
„ List and explain the components of the conceptual framework
„ Explain the difference between the accruals, cash and break up basis of accounting
„ Prepare simple cash and break up basis financial statements
„ Explain the measurement bases available under IFRS
„ Explain and illustrate the capital maintenance concepts described in the conceptual
framework
„ Explain the meaning of true and fair or fairly presented

Chapter 2: Accounting and reporting concepts, frameworks and practices
1 A CONCEPTUAL FRAMEWORK FOR FINANCIAL REPORTING
The meaning ofGAAP

The meaning of a conceptual framework
The purpose of a conceptual framework
The alternative to a conceptual framework
1.1 The meaning of GAAP

The preparation and presentation of financial statements is based on a large
number of concepts, principles and detailed rules. Some of these are contained
in law, and others are in financial reporting standards. Many of the most
fundamental concepts are not contained in any law or regulation or standard, but
are simply accepted accounting principles and conventions.
All the concepts, principles, conventions, laws, rules and regulations that are
used to prepare and present financial statements are known as Generally
Accepted Accounting Principles or GAAP.
‘Generally accepted accounting principles’ vary from country to country, because
each country has its own legal and regulatory system. The way in which
businesses operate also differs from country to country. (For example, there is US
GAAP, UK GAAP and Nigerian GAAP).
Many countries have now adopted International Financial Reporting Standards or
IFRSs, sometimes called international accounting standards. It is now fairly
common to refer to the totality of the rules as IFRS or IAS.
1.2 The meaning of a conceptual framework

A conceptual framework is a system of concepts and principles that underpin the
preparation of financial statements. These concepts and principles should be
consistent with one another.
The International Accounting Standards Committee (the predecessor of the
IASB) issued a conceptual framework document in 1989. This was called the
Framework for the Preparation and Presentation of Financial Statements and
was adopted by the IASB.
The IASB has been working closely with FASB (the US standard setter) on a
wide range of projects with the aim of converging IFRS and US GAAP. One of
the projects has had the aim of producing a conceptual framework common to
each GAAP.
The new conceptual framework was developed on a chapter by chapter basis.
The complete new conceptual framework was published in March 2018 and is
called” The conceptual framework for financial reporting”.
Note that the changes are not fundamental in terms of their impact on IFRS.

Financial reporting
The new document is made up of the following sections:

‰ Chapter 1 – The objective of general-purpose financial reporting.
‰ Chapter 2 – Qualitative characteristics of useful financial information.
‰ Chapter 3 – Financial statements and the reporting entity.
‰ Chapter 4 – The elements of financial statements.
‰ Chapter 5 – Recognition and derecognition.
‰ Chapter 6 –Measurement.
‰ Chapter 7 – Presentation and disclosure.
‰ Chapter 8 – Concepts of capital and capital maintenance.
1.3 The purpose of a conceptual framework

Most preparers and users of financial statements recognise that there is a need
for a formal conceptual framework and that this can be useful in a number of
ways.
Where there is a formal conceptual framework for accounting, accounting
practice and accounting standards are based on this framework.
Lack of a formal framework often means that standards are developed randomly
or only to deal with particular problems. The result is that standards are
inconsistent with each other or with legislation.
Lack of a conceptual framework may also mean that accounting standards fail to
address important issues. For example, until the IASB developed its Framework,
there was no proper definition of terms such as ‘asset’, ‘liability’, ‘income’ and
‘expenses’.
The business environment is becoming increasingly complex. It is unlikely that
accounting standards can cover all possible transactions. Where an entity enters
into an unusual transaction and there is no relevant accounting standard, it can
refer to the framework and apply the principles in it.
It can also be argued that a conceptual framework strengthens the credibility of
financial reporting and the accounting profession in general.
1.4 The alternative to a conceptual framework

The alternative to a system based on a conceptual framework is a system based
on detailed rules.
Accounting standards based on detailed rules are open to abuse. ‘Creative
accounting’ is the name given to techniques which enable management to give a
biased impression (usually favourable) of the company’s performance while still
complying with accounting standards and other regulations. During the 1980s
there were a number of scandals in which investors were misled by the financial
statements of apparently healthy companies which then collapsed. This was one
of the original reasons why the IASB and other standard setters developed their
conceptual frameworks. Principles are normally much harder to evade than rules.
Another disadvantage of a rule-based system is that standard setters are more
likely to be influenced by ‘vested interests’ such as large companies or a
particular business sector. The existence of a conceptual framework is an
important safeguard against this kind of political pressure.

Despite these problems, some preparers and regulators still appear to favour rule
based standards. Standards based on principles may require management to use
its judgement (and to risk making a mistake), while rules simply need to be
followed. This can be important where management can face legal action if an
investor makes a poor decision based on the financial statements.
The use of a conceptual framework can lead to standards that are theoretical and
complex. They may give the ‘right answer’ but be very difficult for the ordinary
preparer to understand and apply. However, a system of extremely detailed rules
can also be very difficult to apply.
2 THE IASB CONCEPTUAL FRAMEWORK
Introduction
Users and their information needs
Chapter 1: Objective of general purpose financial statements
Chapter 3: Financial statements and the reporting entity
2.1 Introduction
Financial reports are based on estimates, judgements and models rather than
exact depictions. The Conceptual Framework establishes the concepts that
underlie those estimates, judgements and models.
The Conceptual Framework deals with:
▪ the objective of financial reporting;
▪ the qualitative characteristics of useful financial information;
▪ the definition, recognition and measurement of the elements from which
financial statements are constructed; and
▪ concepts of capital and capital maintenance.
The Conceptual Framework sets out the concepts that underlie the preparation
and presentation of financial statements for external users. Its purpose is to:
▪ assist the IASB to develop IFRS Standards (Standards) that are based on
consistent concepts;
▪ assist preparers to develop consistent accounting policies when no
standard applies to a particular transaction or other event, or when IFRS
allows a choice of accounting policy; and
▪ assist all parties to understand and interpret IFRS.
This Conceptual Framework is not an IFRS and nothing in the Conceptual
Framework overrides any specific IFRS.
On very rare occasions there may be a conflict between the Conceptual
Framework and an IFRS. In those cases, the requirements of the IFRS prevail
over those of the Conceptual Framework.
2.2 Users and their information needs

Many existing and potential investors, lenders and other creditors cannot require
reporting entities to provide information directly to them and must rely on general
purpose financial reports for much of the financial information they need. These
are the primary users to whom general purpose financial reports are directed.
‰ General purpose financial reports cannot provide all the information needed and
users also need to consider pertinent information from other sources.
‰ General purpose financial reports do not show the value of a reporting entity;
but they provide information to help users estimate a value.
‰ Individual primary users have different information needs. The aim of IFRSs
is to provide information that will meet the needs of the maximum number of
primary users.
Other users
‰ Regulators and members of the public other than investors, lenders and
other creditors, may also find general purpose financial reports useful but
these reports are not primarily directed to these groups.
‰ A company’s management is often interested in financial information but
the management do not need to rely on general purpose financial reports.
2.3 Chapter1: Objective of general purpose financial statements

The objective of general purpose financial reporting forms the foundation of the
Conceptual Framework. Other aspects of the Conceptual Framework flow
logically from the objective.
The objective
The objective of general purpose financial reporting is to provide financial
information about the reporting entity that is useful to existing and potential
investors, lenders and other creditors in making decisions about providing
resources to the entity.
Those decisions involve buying, selling or holding equity and debt instruments,
and providing or settling loans and other forms of credit.
‰ In order to make these decisions the users need information to help them
assess the prospects for future net cash inflows to anentity.
‰ In order to assess an entity’s prospects for future net cash inflows, users
need information about:
x the resources of the entity;
x claims against the entity; and
x how efficiently and effectively the entity’s management have
discharged their responsibilities to use the entity’s resources. (This
information is also useful for decisions by those who have the right to
vote on or otherwise influence management performance).
Information provided
General purpose financial statements provide information about:
‰ the financial position of the entity – information about economic resources
and the claims against them; and
‰ changes in its financial position which could be due to:
x financial performance; and/or
x other events or transactions (e.g share issues).

Economic resources and claims
Information about the nature and amounts of economic resources and claims can
help users to:
‰ identify the financial strengths and weaknesses of a reporting entity;
‰ to assess a reporting entity’s liquidity and solvency and its needs for
additional financing;
Information about priorities and payment requirements of existing claims helps
users to predict how future cash flows will be distributed among those with a
claim against the reporting entity.
Changes in economic resources and claims – Financial performance
Accrual accounting depicts the effects of transactions and other events and
circumstances on a reporting entity’s economic resources and claims in the
periods in which those effects occur, even if the resulting cash receipts and
payments occur in a different period.
This is important because such information provides a better basis for assessing
the entity’s past and future performance than information solely about cash
receipts and payments during that period.
Importance of information about a reporting entity’s financial performance:
▪ It helps users to understand the return generated from its economic
resources. This in turn provides an indication of how well management has
discharged its responsibilities to make efficient and effective use of these
resources.
▪ It shows the capacity of a reporting entity to generate net cash inflows
through its operations rather than by obtaining additional resources
directly from investors and creditors.
▪ It gives an indication of the extent to which events such as changes in
market prices or interest rates affect its ability to generate net cash inflows.
▪ Information about the variability and components of return is also important,
especially in assessing the uncertainty of future cashflows.
▪ Information about past financial performance is helpful in predicting
the entity’s future returns on its economic resources.
Another aspect of performance is management of cash flow. Information about a
reporting entity’s cash flows during a period helps users to assess the entity’s
ability to generate future net cash inflows. It indicates how the reporting entity
obtains and spends cash, including information about its borrowing and
repayment of debt, cash dividends or other cash distributions to investors, and
other factors that may affect the entity’s liquidity or solvency. Information about
cash flows helps users understand a reporting entity’s operations, evaluate its
financing and investing activities, assess its liquidity or solvency and interpret
other information about financial performance.
Changes in economic resources and claims – Other events and transactions

Information about this type of change is necessary to give users a complete
understanding of why the reporting entity’s economic resources and claims
changed and the implications of those changes for its future financial
performance.

Objectives of financial statements: summary

The objectives of financial statements are met by:
• the main financial statements (statement of financial position, statement
of profit or loss and other comprehensive income (or statement of profit or
loss and statement of other comprehensive income), statement of cash
flows, and statement of changes in equity), and
• supporting notes to the accounts, which provide additional details.
2.4 Chapter3: Financial statements and the reporting entity
Objective and scope of financial statements

The objective of financial statements is to provide financial information about the
reporting entity’s assets, liabilities, equity, income and expenses that is useful to
users of financial statements in assessing the prospects for future net cash
inflows to the reporting entity and in assessing management’s stewardship of the
entity’s economic resources.
That information is provided:
‰ in the statement of financial position, by recognising assets, liabilities and
equity;
‰ in the statement(s) of financial performance, by recognising income and
expenses; and
‰ in other statements and notes, by presenting and disclosing information
about:
x recognised and unrecognised assets and liabilities, equity, income
and expenses;
x cashflows;
x contributions from holders of equity claims and distributions to them;
and
x the methods, assumptions and judgements used in estimating the
amounts presented or disclosed, and changes in those methods,
assumptions and judgements.
Reporting period
Financial statements are prepared for a specified period of time (reporting period)
and provide information about:
‰ assets and liabilities (including unrecognised assets and liabilities) and
equity that existed at the end of the reporting period, or during the reporting
period; and
‰ income and expenses for the reporting period.

Perspective
Financial statements provide information viewed from the perspective of the
reporting entity as a whole.
Going concern assumption

Financial statements are normally prepared on the assumption that the reporting
entity is a going concern and will continue in operation for the foreseeable future.
It is assumed that the entity does not intend or need to enter liquidation or to
cease trading. If that is not the case, the financial statements may have to be
prepared on a different basis and the basis used must be described.
The reporting entity

A reporting entity is one that prepares financial statements.
A reporting entity can be a single entity or a portion of an entity or can comprise
more than one entity (e.g., a group).
A reporting entity is not necessarily a legal entity.
It can be difficult to determine the boundary of a reporting entity that is not a legal
entity. In this case the boundary is determined by taking into account the
information needs of the primary users.
3 QUALITATIVE CHARACTERISTICS OF USEFUL FINANCIAL

INFORMATION
Introduction
Relevance
Faithful representation
Enhancing qualitative characteristics
Cost constraint on useful information
3.1 Introduction
This is covered by chapter 2 of The IASB Conceptual Framework.
Information must have certain characteristics in order for it to be useful for
decision making. The IASB Conceptual Framework describes:
fundamental qualitative characteristics; and
enhancing qualitative characteristics
Fundamental qualitative characteristics:
‰ relevance; and
‰ faithful representation
The qualitative characteristics that enhance the usefulness of information that is
relevant and a faithful representation are:
‰ comparability;
‰ verifiability
‰ timeliness; and
‰ understandability
“If financial information is to be useful, it 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”.
Emphasis
Information must be both relevant and faithfully represented if it is to be useful.
The enhancing qualitative characteristics cannot make information useful if that
information is irrelevant or not faithfully represented.
3.2 Relevance
Information must be relevant to the decision-making needs of users. Information
is relevant if it can be used for predictive and/or confirmatory purposes.
‰ It has predictive value if it helps users to predict what might happen in the
future.
‰ It has confirmatory value if it helps users to confirm the assessments and
predictions they have made in the past.
The relevance of information is affected by its materiality.
Information is material if omitting it or misstating it could influence decisions that
users make on the basis of financial information about a specific reporting entity.
‰ Materiality is an entity-specific aspect of relevance based on the nature or
magnitude (or both) of the items to which the information relates in the
context of an individual entity’s financial report.
‰ Therefore, it is not possible for the IASB to specify a uniform quantitative
threshold for materiality or predetermine what could be material in a
particular situation.
3.3 Faithful representation

Financial reports represent economic phenomena (economic resources, claims
against the reporting entity and the effects of transactions and other events and
conditions that change those resources and claims) by depicting them in words
and numbers.
To be useful, financial information must not only represent relevant phenomena,
but it must also faithfully represent the phenomena that it purports to represent.
A perfectly faithful representation would have three characteristics. It would be:
‰ complete – the depiction includes all information necessary for a user to
understand the phenomenon being depicted, including all necessary
descriptions and explanations.
‰ neutral – the depiction is without bias in the selection or presentation of
financial information;and
‰ free from error – whe re there are no errors or omissions in the
description of the phenomenon, and the process used to produce the
reported information has been selected and applied with no errors in the
process.

3.4 Enhancing qualitative characteristics
Comparability
Comparability is the qualitative characteristic that enables users to identify and
understand similarities in, and differences among, items
Information about a reporting entity is more useful if it can be compared with
similar information about other entities and with similar information about the
same entity for another period or another date.
Consistency is related to comparability but is not the same. Consistency refers to
the use of the same methods for the same items, either from period to period within
a reporting entity or in a single period across entities. Consistency helps to achieve
the goal of comparability.
Verifiability
This quality helps assure users that information faithfully represents the
economic phenomena it purports to represent.
‰ Verifiability means that different knowledgeable and independent observers
could reach consensus that a particular depiction is a faithful representation.
‰ Quantified information need not be a single point estimate to beverifiable.
A range of possible amounts and the related probabilities can also be
verified.
Timeliness
This means having information available to decision-makers in time to be capable
of influencing their decisions.
Understandability
Information is made understandable by classifying, characterising and presenting
it in a clear and concise manner.
Financial reports are prepared for users who have a reasonable knowledge of
business and economic activities and who review and analyse the information
diligently.
3.5 Cost constraint on useful information

Reporting financial information that is relevant and faithfully represents what it
purports to represent helps users to make decisions with more confidence. This
results in more efficient functioning of capital markets and a lower cost of capital
for the economy as a whole. An individual investor, lender or other creditor also
receives benefits by making more informed decisions. However, it is not possible
for general purpose financial reports to provide all the information that every user
finds relevant.
The benefits obtained from financial information should exceed the cost of
obtaining and providing it. Information should not be provided if the cost is not
worth the benefit.
Since it is difficult to measure the benefits of financial information, the setters of
accounting standards must use their judgement in deciding whether certain items
of information should be provided in the financial statements (and if so, in how
much detail).

Financial reporting
4 THE ELEMENTS OF FINANCIAL STATEMENTS
Section overview
„ Introduction
„ Assets
„ Liabilities
„ Other definitions
4.1 Introduction
The IASB Framework discusses the five elements of financial statements:
‰ for reporting financial position: assets, liabilities and equity; and
‰ for reporting financial performance: income and expenses.
4.2 Assets
An asset is 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.
Rights
Rights can take many forms including the right to receive cash, exchange
resources on favourable terms, rights over physical objects and rights to use
intellectual property.
Many rights are established by contract, legislation or similar means.
However, rights might be obtained in other ways (e.g., developing know-how that
is not in the public domain).
Some goods or services are received and immediately consumed (e.g., employee
services). The right to obtain the economic benefits produced by such goods or
services exists momentarily until the entity consumes the goods or services.
In order to be an asset, rights must both have the potential to produce economic
benefits for the entity beyond those available to all other parties and be controlled
by the entity. Therefore, not all rights are assets (e.g., right to use public
infrastructure is not an asset).
Potential to produce economic benefits

An economic resource is a right that has the potential to produce economic
benefits.
A right can be an asset, even if the probability that it will produce economic
benefits is low. However, low probability might affect decisions about what
information to provide about the asset and how to provide that information,
including decisions about whether the asset is recognised and how it is
measured.

Control
Control links an economic resource to an entity
Control is the ability to obtain economic benefits from the asset, and to restrict
the ability of others to obtain the same benefits from the same item.
4.3 Liabilities
A liability is a present obligation of the entity to transfer an economic resource as
a result of past events.
For a liability to exist, three criteria must all be satisfied:
‰ the entity has an obligation;
‰ the obligation is to transfer an economic resource; and
‰ the obligation is a present obligation that exists as a result of past events
Obligation
An obligation is a duty or responsibility that an entity has no practical ability to
avoid.
An obligation is always owed to another party (or parties) but it is not necessary
to know the identity of the party (or parties) to whom the obligation is owed.
Obligations might be established by contract or other action of law or they might
be constructive. A constructive obligation arises from an entity’s customary
practices, published policies or specific statements when the entity has no
practical ability to act in a manner inconsistent with those practices, policies or
statements.
Transfer of economic resource

An obligation must have the potential to require the entity to transfer an economic
resource to another party (or parties).
An obligation can meet the definition of a liability even if the probability of a transfer
of an economic resource is low. However, low probability might affect decisions
about what information to provide about the liability and how to provide that
information, including decisions about whether the liability is recognised and how
it is measured.
Present obligation as a result of past events

A liability is an obligation that already exists. An obligation may be legally
enforceable as a result of a binding contract or a statutory requirement, such as a
legal obligation to pay a supplier for goods purchased.
Obligations may also arise from normal business practice, or a desire to maintain
good customer relations or the desire to act in a fair way. For example, an entity
might undertake to rectify faulty goods for customers, even if these are now
outside their warranty period. This undertaking creates an obligation, even though
it is not legally enforceable by the customers of the entity.
Past transactions or events

A liability arises out of a past transaction or event.
A present obligation exists as a result of past events only if:
the entity has already obtained economic benefits or taken an action; and
as a consequence, the entity will or may have to transfer an economic
resource that it would not otherwise have had to transfer.
Financial reporting
For example, a trade payable arises out of the past purchase of goods or
services, and an obligation to repay a bank loan arises out of past borrowing.
4.4 Otherdefinitions
Equity
Equity is the residual interest in an entity after the value of all its liabilities has
been deducted from the value of all its assets.
Income
Income is increases in assets, or decreases in liabilities, that result in increases
in equity, other than those relating to contributions from holders of equity claims.
The concept of income includes both revenue and gains.
‰ Revenue is income arising in the course of the ordinary activities of the
entity. It includes sales revenue, fee income, royalties income, income and
income from investments (interest and dividends). Revenue is recognised
in the statement of profit or loss.
‰ Gains represent other items that meet the definition of income. Gains may
be recognised in the statements of profit or loss or in the statement of other
comprehensive income. For example:
x Income includes gains on the disposal of non-current assets. These
are recognised in the statement of profit or loss.
x Income also includes unrealised gains which occur whenever an asset
is revalued upwards but is not disposed of. For example, an unrealised
gain occurs when a property owned by the entity is revalued upwards.
Unrealised gains might be recognised in the statement of profit or loss
(e.g. revaluation gains on property accounted for under IAS 16) or in
the statement of other comprehensive income (e.g. revaluation gains
on property accounted for under the IAS 40 fair value model).
Expenses
Expenses are decreases in assets, or increases in liabilities, that result in
decreases in equity, other than those relating to distributions to holders of equity
claims.
Expenses include:
‰ Expenses arising in the normal course of activities, such as the cost of sales
and other operating costs, including depreciation of non-current assets.
Expenses result in the outflow of assets (such as cash or finished goods
inventory) or the depletion of assets (for example, the depreciation of non-
current assets).
‰ Losses include for example, the loss on disposal of a non-current asset,
and losses arising from damage due to fire or flooding. Losses are usually
reported as net of related income.
Financial performance is measured by profit or loss and gains or losses

recognised in other comprehensive income. Profit is measured as income less
expenses.

5 RECOGNITION AND DERECOGNITION
Section overview
„ Recognition
„ Recognition criteria
„ Commentary on the new recognition criteria
„ Derecognition
5.1 Recognition
Recognition is the process of capturing for inclusion in the statement of financial
position or the statement(s) of financial performance an item that meets the
definition of one of the elements of financial statements.
Recognition involves depicting the item in words and by a monetary amount.
The amount at which an asset, a liability or equity is recognised in the statement
of financial position is referred to as its carrying amount.
Recognition links the elements as the recognition of one item (or a change in its
carrying amount) requires the recognition or derecognition of another item. For
example, revenue is recognised at the same time as the corresponding
receivable.
5.2 Recognition criteria

Only items that:
‰ meet the definition of an asset, a liability or equity are recognised in the
statement of financial position; or
‰ meet the definition of income or expenses are recognised in the
statement(s) of financial performance.
However, not all items that meet the definition of one of those elements 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, i.e. with:
‰ relevant information about the asset or liability and about any resulting
income, expenses or changes in equity; and
‰ a faithful representation of the asset or liability and of any resulting income,
expenses or changes in equity.
Information about an asset or liability may not be relevant when there is
uncertainty about its existence or when there is only a low probability of an inflow
or outflow of economic benefits in respect of that asset or liability.
Whether a faithful representation can be provided may be affected by the level of
measurement uncertainty associated with the asset or liability or by other factors.

5.3 Commentary on the new recognition criteria

Under the previous framework, an asset or liability would be recognised when:
‰ it meets the definition of an element: and
‰ satisfies the following two criteria:
x it must be probable that the future economic benefit associated with
the item will flow either into or out of the entity; and
x The item should have a cost or value that can be measured reliably.
The IASB’s deliberations on this and other projects have led them to the
conclusion that the probability of an inflow or outflow is not a recognition attribute
but a measurement attribute.
The practical impact of the change in focus of the criteria will be negligible but is
believed to provide a stronger conceptual foundation to the recognition process.
5.4 Derecognition
Derecognition is the removal of all or part of a recognised asset or liability from
an entity’s statement of financial position.
This normally occurs when that item no longer meets the definition of an asset or
of a liability:
‰ for an asset, derecognition normally occurs when the entity loses control of
all or part of the recognised asset; and
‰ for a liability, derecognition normally occurs when the entity no longer has a
present obligation for all or part of the recognised liability.
6 ACCOUNTING CONCEPTS
Consistency of presentation
Materiality and aggregation
Offsetting
In addition to the accounting concepts in the IASB Framework, some other accounting
concepts are used in financial reporting. These concepts, together with the underlying
assumptions of going concern and accruals, are explained in IAS 1 Presentation of
6.1 Consistency of presentation

Consistency of presentation is needed if financial information is to be
comparable. IAS 1 states that there should be consistency in the presentation
and classification of items in the financial statements from one year to the next.
There are just two exceptions to the requirement for consistency:
‰ Consistency is not required when it is apparent, following a significant change
in the entity’s operations or a review of its financial statements, that a different
presentation or classification would be more appropriate.
‰ Consistency is not appropriate if a new accounting standard (or the
interpretation of a Standard by IFRIC) requires a change in the presentation of
information.
Financial reporting
6.2 Materiality and aggregation

IAS 1 also states that each material class of similar items should be presented
separately in the financial statements.
In addition, items of a dissimilar nature should not be aggregated together in the
financial statements (combined as a single item and in a single total), unless their
value is immaterial.
6.3 Offsetting
IAS 1 states that:
‰ Assets and liabilities should not be offset against eachother.
‰ Similarly, incomes and expenses should not be offset against each other.
Instead they should be reported separately.
The exceptions to this rule are when:
‰ offsetting is required or permitted by an accounting standard or the
Interpretation of astandard offsetting reflects the economic substance of a
transaction. An example specified in IAS 1 is reporting of a gain or loss on
disposal of a non-current asset at sale value minus the carrying value of the
asset and the related selling expenses.
7 Presentation and disclosures and bases of accounting
Presentation and disclosure

Accruals basis of accounting (matching concept)
Cash basis of accounting
Break-up basis of accounting
7.1 Introduction
There are three bases of accounting which go to the heart of how transactions
are recognised and measured:
‰ Accruals basis;
‰ cash basis; and
‰ break upbasis
The accruals basis is by far the most important and popularly applied of these
three in practice.
7.2 Accruals basis of accounting (matching concept)

Accruals basis accounting (accruals accounting, the accruals concept) recognises
transactions and other events and circumstances in the periods in which those
effects occur, even if the resulting cash receipts and payments occur in a different
period.
‰ Revenue from sales and other income should be reported in the period
when the income arises (which might not be the same as the period when
the cash is received).
‰
‰ The cost of sales in the statement of comprehensive income must be
matched with the sales. Income and ‘matching’ expenses must be reported
in the same financial period.
‰ Other expenses should be charged in the period to which they relate, not
the period in which they are paid,
7.3 Cash basis of accounting

Cash basis accounting recognises transactions in the periods in which cash
receipts and payments occur.
‰ Revenue from sales and other income will be reported in the period when
the cash is received (which might be in a later period than when the income
arises).
‰ Expenses are charged in the period to which they are paid, not the period in
which they are incurred.
Over time the accruals based accounting and cash based accounting result in
recognising the same amounts. However, transactions might be recognised in
different periods, under each system.
Example: Accruals vs cash basis

A company prepares its financial statements to the 31 December each year.
It sells goods for ₦50,000 to a customer on 6 December Year 2 but does not receive
a cash payment from the customer until 15 January Year 3.
Accruals basis
The sale is recognised as income in the year to 31 December Year 2, even though
the cash is not received until after the end of this financial year.
Cash basis
The sale is recognized as income in Year 3, even though sale was made in year 2.
₦50,000 is recognised as revenue under each basis but in different periods.
Example: Accruals vs cash basis

A company starts in business on 1 September Year 1. It acquires an office for
which it pays one year’s rent in advance, to 31 August Year 2.
The cost of the annual rental is ₦120,000. The company prepares its financial
statements for a financial.
Accruals basis
The office rental cost in the period to 31 December Year 1 is the cost of just four
months’ rent.
The expense is therefore ₦40,000 (₦120,000u4/12) in Year 1, and there has been a
prepayment for ₦80,000 that relates to the next financial period, the year to 31
December Year 2.
Cash basis
The entire cost is recognised in the year to 31 December Year 1.

7.4 Break-up basis ofaccounting

Both the accruals basis and the cash basis assume that a business is a going
concern. This means that the business is expected to continue into the future.
This may not always be the case.
A business might be brought to an end (wound up) either due to financial
difficulty or, less likely, the owners decide that the business has run its course.
The break-up basis of accounting is used when the business is no longer a going
concern. This basis results in all assets and liabilities being measured at the
amount of cash that they can be sold (assets) or settled (liabilities).
Example: Break-up basis

A company prepares its financial statements to the 31 December each year.
The company is in severe financial difficulty and is not expected to survive. It
has a building in its accounts carried at ₦1,500,000.
Real estate professionals have advised that this building could be sold for only
₦1,200,000 in the current market conditions.
Break-up basis
The building should be remeasured at₦1,200,000 in the financial statements.
.
Presentation and disclosure as communication tools
A reporting entity communicates information about its assets, liabilities, equity, income and
expenses by presenting and disclosing information in its financial statements.
Effective communication of information in financial statements makes that information more

relevant and contributes to a faithful representation of an entity’s assets, liabilities, equity, income
and expenses. It also enhances the understandability and comparability of information in financial
statements.
Effective communication of information in financial statements requires:

(a) focusing on presentation and disclosure objectives and principles rather than focusing on
rules;
(b) classifying information in a manner that groups similar items and separates dissimilar items;
and
(c) aggregating information in such a way that it is not obscured either by unnecessary detail
or by excessive aggregation.
Presentation and disclosure objectives and principles

To facilitate effective communication of information in financial statements, when developing
presentation and disclosure requirements in Standards, a balance is needed between:
(a) giving an entity 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.

Classification
Classification is the sorting of assets, liabilities, equity, income or expenses on the basis of shared
characteristics for presentation and disclosure purposes.
Such characteristics include - but not limited to - the nature of the item, its role (or function) within
the business activities conducted by the entity, and how it is measured.
Classifying dissimilar assets, liabilities, equity, income or expenses together can obscure relevant
information, reduce understandability and comparability, and may not provide a faithful
representation of what it purports to represent.
Classification of assets and liabilities

Classification is applied to the unit of account selected for an asset or liability. However, it may
sometimes be appropriate to separate an asset or liability into components that have different
characteristics and to classify those components separately. That would be appropriate when
classifying those components separately would enhance the usefulness of the resulting financial
information. For example, it could be appropriate to separate an asset or liability into current and
non-current components and to classify those components separately.
Classification of equity
To provide useful information, it may be necessary to classify equity claims separately if those
equity claims have different characteristics (see paragraph 4.65).
Similarly, to provide useful information, it may be necessary to classify components of equity

separately if some of those components are subject to particular legal, regulatory or other
requirements. For example, in some jurisdictions, an entity is permitted to make distributions to
holders of equity claims only if the entity has sufficient reserves specified as distributable (see
paragraph 4.66). Separate presentation or disclosure of those reserves may provide useful
information.
Classification of income and expenses
Classification is applied to:
(a) income and expenses resulting from the unit of account selected for an asset or liability; or
(b) components of such income and expenses if those components have different
characteristics and are identified separately. For example, a change in the current value of
an asset can include the effects of value changes and the accrual of interest (see Table
6.1). It would be appropriate to classify those components separately if doing so would
enhance the usefulness of the resulting financial information.
Profit or loss and other comprehensive income

Income and expenses are classified and included either:
(a) in the statement of profit or loss; or
(b) outside the statement of profit or loss, in other comprehensive income.
The statement of profit or loss is the primary source of information about an entity’s financial
performance for the reporting period. That statement contains a total for profit or loss that provides
a highly summarised depiction of the entity’s financial performance for the period. Many users of
financial statements incorporate that total in their analysis either as a starting point for
that analysis or as the main indicator of the entity’s financial performance for the period.
Nevertheless, understanding an entity’s financial performance for the period requires an analysis
of all recognised income and expenses - including income and expenses included in other
comprehensive income - as well as an analysis of other information included in the financial
statements.

Because the statement of profit or loss is the primary source of information about an entity’s
financial performance for the period, all income and expenses are, in principle, included in that
statement. However, in developing Standards, the Board may decide in exceptional circumstances
that income or expenses arising from a change in the current value of an asset or liability are to be
included in other comprehensive income when doing so would result in the
statement of profit or loss providing more relevant information or providing a more faithful
representation of the entity’s financial performance for that period.
8 MEASUREMENT AND CAPITAL MAINTENANCE
Measurements of elements of financial statements

Fair value
Capital maintenance concepts
8.1 Measurements of elements of financial statements

The Conceptual Framework allows two principal measurement bases that are
used for the elements of financial statements. These include:
Historical cost. Historical cost provides monetary information about assets, liabilities
and related income and expenses, using information derived, from the price of the
transaction or other event that gave rise to them. It does not reflect changes in values,
except to the extent that those changes relate to impairment of an asset or a liability
becoming onerous
The historical cost of an asset when it is acquired or created 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. The historical cost of a liability when
it is incurred or taken on is the value of the consideration received to incur or take on
the liability minus transaction costs.
Current value of the asset or liability is used as a deemed cost on initial recognition
when an asset is acquired or created, or a liability is incurred or taken on, as a result
of an event that is not a transaction on market terms and that deemed cost is then
used as a starting point for subsequent measurement at historical cost. This is
because it may not be possible to identify a cost, or the cost may not provide relevant
information about the asset or liability
‰ Current value
Current value measures provide monetary information about assets, liabilities
and related income and expenses, using information updated to reflect conditions
at the measurement date. Because of the updating, current values of assets and
liabilities reflect changes, since the previous measurement date, in estimates of
cash flows and other factors reflected in those current values. The current value
of an asset or liability is not derived, even in part, from the price of the transaction
or other event that gave rise to the asset or liability
Current value measurement bases include:
(a) fair value;
(b) value in use for assets and fulfilment value for liabilities; and
(c) current cost.
‰ Fair Value
Fair value is the price that would be received to sell an asset, or paid to transfer a
liability, in an orderly transaction between market participants at the measurement
date.
Fair value reflects the perspective of market participants - participants in a market
to which the entity has access. The asset or liability is measured using the same
assumptions that market participants would use when pricing the asset or liability,
if those market participants act in their economic best interest.
In some cases, fair value can be determined directly by observing prices in an
active market. In other cases, it is determined indirectly using measurement
techniques, for example, cash flow-based measurement techniques, reflecting all
the following factors:
(a) estimates of future cash flows;
(b) possible variations in the estimated amount or timing of future cash flows
for the asset or liability being measured, caused by the uncertainty inherent
in the cash flows;
(c) the time value of money;
(d) the price for bearing the uncertainty inherent in the cash flows (a risk
premium or risk discount). The price for bearing that uncertainty depends
on the extent of that uncertainty. It also reflects the fact that investors would
generally pay less for an asset (and generally require more for taking on a
liability) that has uncertain cash flows than for an asset (or liability) whose
cash flows are certain; and
(e) other factors, for example, liquidity, if market participants would take those
factors into account in the circumstances.
Value in use and fulfilment value

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. 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.
Because value in use and fulfilment value are based on future cash flows, they do
not include transaction costs incurred in acquiring an asset or taking on a liability.
However, value in use and fulfilment value include the present value of any
transaction costs an entity expects to incur on the ultimate disposal of the asset
or on fulfilling the liability.
Current cost
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. Current cost, like historical cost, is an entry value: it reflects prices in the
market in which the entity would acquire the asset or would incur the liability.
Hence, it is different from fair value, value in use and fulfilment value, which are
exit values. However, unlike historical cost, current cost reflects conditions at the
measurement date.
In some cases, current cost cannot be determined directly by observing prices in

an active market and must be determined indirectly by other means
Historical cost is the most commonly used measurement basis. However, the other
bases of measurement are often used to modify historical cost. For example,
inventories are measured at the lower of cost and net realisable value. Deferred
income is measured at present value. Some non-current assets may be valued at
current value.
The Framework does not favour one measurement base over the others, however
fair value may be favoured over historical costs for financial instrument and
investment property.
Problems with the use of fair value

Fair value is easy to understand and less complicated to apply than value to the
business/current value. Arguably, it is also more reliable to the business, because
market value is more easily verified than (for example) economic value. However,
it has some serious disadvantages:
‰ There may not be an active market for some kinds of asset. Where there is
no active market, estimates have to be used and these may not be reliable.
‰ It anticipates sales and profits which may never happen (the entity may
have no plans to sell th easset).
‰ Market values can move up and down quite rapidly. This may distort trends
in the financial statements and make it difficult for users to assess an entity’s
performance over time.
A notable example of this problem occurred during 2007 and 2008 with the
collapse of the market for certain types of asset-backed securities (mortgage-
related securities known as CDOs). Many banks, particularly in the US and
Europe, announced huge losses, due largely to the requirement to write down
their investments in these financial instruments to fair value, even though fair
value was difficult to assess.
Despite these problems, it looks increasingly likely that the IASB will require
greater use of fair value in future.
8.2 Capital maintenance concepts

The Conceptual Framework states that there are two concepts of capital:
‰ A financial concept of capital;
‰ A physical concept of capital.
Different systems of accounts used different capital maintenance concepts. The
choice of capital maintenance has a profound effect on the measurement of
profit.
Consider the basic accounting equation.
Formula: Accounting equation

Assets = Liabilities + Equity or Liabilities =
= L + E A =
Net assets

The accounting equation is an equation. Therefore, changes in one side are
matched by changes in the other side.
Profit or loss for a period can be calculated from the difference between the
opening and closing net assets after adjusting for any distributions during the
period.
Formula: Profit
Change in equity = Closing equity – Opening equity
Increase in equity = Profit + capital introduced – distributions
Profit = Increase in equity – capital introduced + distributions
This shows that the value ascribed to opening equity is crucial in the
measurement of profit.
Financial capital maintenance

With the financial concept of capital maintenance, a profit is not earned during
a period unless the financial value of equity at the end of the period exceeds the
financial value of equity at the beginning of the period (after adjusting for equity
capital raised or distributed).
Historical cost accounting is based on the concept of money financial capital
maintenance. Under this concept, an entity makes a profit when its closing equity
exceeds its opening equity measured as the number of units of currency at the
start of the period. Note that this is a separate issue from asset valuation.
Assets could be revalued during the period, but this would have no effect on the
opening capital position.
An alternative view of financial capital maintenance is used in constant
purchasing power accounting. This system is based on the concept of real
financial capital maintenance. Under this concept, an entity makes a profit
when its closing equity exceeds opening equity remeasured to maintain its
purchasing power.
This requires the opening equity to be uplifted by the general inflation rate. This is
achieved by a simple double entry.
Debit Credit
Statement of profit orloss
Inflation reserve
Physical capital maintenance

A physical concept of capital is that the capital of an entity is represented by its
productive capacity or operating capability. Where a physical concept of capital is
used, the main concern of users of the financial statements is with the maintenance
of the operating capability of the entity.
With a physical concept of capital maintenance, a profit is not earned during a
period unless (excluding new equity capital raised during the period and adding
back any distribution of dividends to shareholders) the operating capability of the
business is greater at the end of the period than at the beginning of the period.
This requires the opening equity to be uplifted by the specific rates of inflation
that apply to the individual components of the net assets of the company. Again,
this is achieved by the same simple double entry.
The following example should help you to understand this
Example: Capital maintenance concepts
During the year genera linflation was 5% but the inflation specific to the item
was 10%.
Profit is calculated under each concept in the following ways.
Capital maintenance concept
Financial Financial
(money terms) (realterms) Physical
Statement of profit or loss N N N
Revenue 14,000 14,000 14,000
Cost of sale (10,000) (10,000) (10,000)
Inflation adjustment
(inflation rate applied to
opening equity):
5%u N10,000 (500)
10%u N10,000 (1,000)
4,000 3,500 3,000
Statement of financial
position N N N
Net assets 14,000 14,000 14,000
Equity:
Opening equity
Before adjustment 10,000 10,000 10,000
Inflation reserve
(see above) 500 1,000
After adjustment 10,000 10,500 11,000
Retained profit (profit for the
year) 4,000 3,500 3,000
14,000 14,000 14,000

Commentary on the example

Under historical cost accounting, the profitis N4,000. If the business paid this out
as a dividend it would have N10,000 left.
N10,000 is the opening equity expressed as a number of units of currency. This
means that the company would have maintained its equity expressed as a
number of units of currency. However, inflation in the period has caused the
purchasing power of the currency to decline. This means that N10,000 no longer
has the same purchasing power that it had a year ago. The company has not
maintained its capital in real terms.
To maintain its opening equity in real terms the company would have to ensure
that it had the same purchasing power at the year-end as it had at the start.
Inflation was 5% so the company would need N10,500 at the year-end in order to
have the same purchasing power as it had at the start of the year. The
company can achieve this by transferring N500 from profit and loss into an inflation
reserve. Profit would then be reported as N3,500.
If the business paid out N3,500 as a dividend it would have N10,500 left. This is
not enough to buy the same as set that it had at the start of the year. The
asset has been subject to specific inflation of 10% therefore the company
would need N11,000 at the year-end in order to buy the same asset.
This means that the company would not have the same capacity to operate as it
had a year ago.
To maintain its opening equity in physical terms the company would have
to ensure that it had the same ability to operate at the year-end as it had
at the start. In other words it would need to have N11,000. The company can
achieve this by transferring N1,000 from profit and loss into an inflation reserve.
Profit would then be reported as N3,000.
Comparing the two concepts

Neither the IASB Conceptual Framework nor accounting standards require the
use of a specific capital maintenance concept. In practice, almost all entities use
money financial capital maintenance, but both concepts can provide useful
information.
Financial capital maintenance is likely to be the most relevant to investors as they
are interested in maximising the return on their investment and therefore its
purchasing power.
Physical capital maintenance is likely to be most relevant to management and
employees as they are interested in assessing an entity’s ability to maintain its
operating capacity. This is particularly true for manufacturing businesses, where
management may need information about the ability of the business to continue
to produce the same or a greater volume of goods.

Financial reporting
9 FAIR PRESENTATION
What is meant by fair presentation (or a true and fairview)?

Fair presentation and compliance withIFRSs
Where fair presentation conflicts with an accounting standard
9.1 What is meant by fair presentation (or a true and fair view)?
Financial statements are often described as showing a ‘true and fair view’ or
‘presenting fairly’ the financial position and performance of an entity, and changes
in its financial position. In some countries (for example, in Nigeria) this is the central
requirement of financial reporting.
Under ‘international GAAP’ (specifically IAS 1) financial statements are required to
present fairly the financial position, financial performance and cash flows of the
entity.
The Framework does not deal directly with this issue. However, it does state that
if an entity complies with international accounting standards, and if its financial
information has the desirable qualitative characteristics of information, then its
financial statements ‘should convey what is generally understood as a true and
fair view of such information’.
IAS 1 states that: ‘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 as
set out in the IASB Framework.
The use of the term faithful representation means more than that the amounts in
the financial statements should be materially correct. It implies that information
should present clearly the transactions and other events that it is intended to
represent. To provide a faithful representation, financial information must account
for transactions and other events in a way that reflects their substance and
economic reality (in other words, their true commercial impact) rather than their
legal form. If there is a difference between economic substance and legal form, the
financial information should represent the economic substance.
Faithful representation also implies that the amounts in the financial statements
should be classified and presented, and disclosures made in such a way that
important information is not obscured and users are not misled.
9.2 Fair presentation and compliance with IFRSs

The application of IFRSs, with additional disclosure when necessary, is presumed
to result in financial statements that achieve a fair presentation.’ IAS 1 states that:
‰ When the financial statements of an entity comply fully with International
Financial Reporting Standards, this fact should be disclosed.
‰ An entity should not claim to comply with IFRSs unless it complies with all
the requirements of every applicable standard.
IAS 1 appears to equate fair presentation with compliance with accounting
standards.

In some situations, fair presentation may require more than this. It is important to
apply the spirit (or general intention) behind an accounting standard as well as
the strict letter (what the standard actually says).
The requirement to ‘present fairly’ also applies to transactions which are not
covered by any specific accounting standard. It is worth noting that there is no
IFRS that covers complex transactions and arrangements which have been
deliberately structured so that their economic substance is different from their
legal form.
IAS 1 states that a fair presentation requires an entity:
▪ to select and apply accounting policies in accordance with IAS 8
Accounting policies, changes in accounting estimates and errors. IAS 8
explains how an entity should develop an appropriate accounting policy
where there is no standard.
▪ to present information in a manner that provides relevant, reliable,
comparable and understandable information
▪ to provide additional disclosures where these are necessary to enable
users to understand the impact of particular transactions and other events
on the entity’s financial performance and financial position (even where
these are not required by IFRSs).
9.3 Where fair presentation conflicts with an accounting standard

IAS 1 acknowledges that in extremely rare circumstances, compliance with a
standard or an Interpretation may produce financial statements that are so
misleading that they do not provide useful information and no longer give a fair
presentation.
An entity can then depart from the requirements of the standard or Interpretation.
It must disclose:
▪ that management has concluded that the financial statements present fairly
the entity’s financial position, financial performance and cashflows;
▪ that it has complied with applicable standards and Interpretations, except
that it has departed from a particular requirement to achieve a fair
presentation;
▪ the title of the standard or Interpretation from which the entity has departed,
the nature of the departure, including the treatment that the standard or
Interpretation would require, the reason why that treatment would be
misleading, and the treatment adopted; and
▪ for each period presented, the financial impact of the departure on each item
in the financial statements that would have been reported in complying with
the requirement.

Financial reporting
10 CHAPTER REVIEW
Explain the objectives of financial statements
List and explain the components of the conceptual framework
Explain the difference between the accruals, cash and break up basis of
accounting
Prepare simple cash and break up basis financial statements
Explain the measurement bases available underIFRS
Explain and illustrate the capital maintenance concepts described in the
conceptual framework
Explain the meaning of true and fair or fairly presented

CHAPTER
Contents
The components of financial statements
General features of financial statements
Structure and content of the statement of financial
position
Structure and content of the statement of profit or loss
and other comprehensive income
Statement of changes in equity (SOCIE)
Notes to the financial statements
Financial statements – Specimen formats
Technique of preparing financial statements
Chapter review

Financial reporting
INTRODUCTION
Aim
principles.
Detailed syllabus
b Prepare and present general purpose financial statements including
statement of financial position, statement of profit or loss and other
comprehensive income, statement of changes in equity and relevant notes
in accordance with IAS 1 – Presentation of financial statements.
IAS 1 is an examinable document for this syllabus.

Exam context
This chapter explains the main features of IAS 1 and IAS 10
By the end of this chapter you will be able to:

„ State the components of a set of financial statements according to IAS1
„ Explain the general features of financial statements described in IAS1
„ Define current and non-current assets
„ Define current and non-current liabilities
„ Explain the IAS 1 guidance on the structure of the statement of financial position, the
statement of profit or loss and other comprehensive income and the statement of
changes inequity
„ Describe the IAS 1 rules on notes to the financial statements

Chapter 3: Presentation of financial statements
1 THE COMPONENTS OF FINANCIAL STATEMENTS
Preparing financial statements

The format of published accounts
1.1 Preparing financial statements

The basic approach to preparing a statement of financial position and a
statement of profit or loss in practice can be summarised as follows.
‰ The balances on all the accounts in the general ledger (nominal ledger or
main) are extracted into a trial balance. (A list of balances on all ledger
accounts for assets, liabilities, capital, income and expenses).
‰ Adjustments are made for ‘year-end’ items, such as:
x depreciation charges for non-current assets;
x accruals and prepayments for expense items;
x adjusting the allowance for bad (irrecoverable) debts;
x closing inventory; and
x other items and transactions not yet recorded or incorrectly recorded.
‰ The adjusted income and expense balances are entered into a statement of
profit or loss to establish the profit or loss for the period.
‰ The adjusted asset, liability and capital balances, together with the retained
profit for the year, are entered into a statement of financial position as at the
end of the reporting period.
This process can be used to prepare the statement of profit or loss and statement
of financial position of a sole proprietor, a partnership or a company.
It is likely that you will be given a trial balance with information about missing or
incorrectly treated items. You will then be asked to construct a statement of
financial position and a statement of profit or loss.

Financial reporting
1.2 The format of published accounts

Many entities must publish financial statements in accordance with International
Financial Reporting Standards and International Accounting Standards. IAS 1:
Presentation of Financial Statements, sets out the rules on the form and
content of financial statements which such entities must comply with.
Definition
General purpose financial statements (referred to as ‘financial statements’)
are those intended to meet the needs of users who are not in a position to require
an entity to prepare reports tailored to their particular information needs.
IAS 1 specifies what published ‘general-purpose’ financial statements should

include, and provides formats for a statement of financial position, statement of
profit or loss and other comprehensive income, and statement of changes in
equity.
The objective of general-purpose financial statements is to provide information
about the financial position of the company, and its financial performance and
cash flows, that is useful to a wide range of users in making economic decisions.
A complete set of financial statements consists of:
‰ a statement of financial position as at the end of the period;
‰ a statement of profit or loss and other comprehensive income for the period
(made up of a statement of profit or loss and a statement of other
comprehensive income);
‰ a statement of changes in equity for the period;
‰ a statement of cash flows (this is dealt with in a later chapter); and
‰ notes to these statements, consisting of a summary of significant
accounting policies used by the entity and other explanatory notes.
Further requirements include:

‰ Financial statements should present fairly the financial position, financial
performance and cash flows of the entity.
‰ Comparative information for the immediate preceding accounting period
should bedisclosed.
‰ Each component of the financial statements must be properly identified with
the following information displayed prominently:
x the name of the reporting entity
x the date of the end of the reporting period or the period covered by
the statement, whichever is appropriate
x the currency in which the figures are reported
x the level of rounding used in the figures (for example, whether the
figures are thousands of naira or millions of naira).
Note: IAS 1 does not specify what the statements must be called and allows the
use of other terminology. For example a statement of financial position is often
called a balance sheet and a statement of profit or loss is often called an income
statement.

2 GENERAL FEATURES OF FINANCIAL STATEMENTS
Introduction
Fair presentation and compliance with IFRSs
Going concern
Accrual basis of accounting
Materiality and aggregation
Offsetting
Frequency of reporting
Comparative information
Consistency of presentation
2.1 Introduction
IAS 1 describes and provides guidance on the following general features of
financial statements:
‰ Fair presentation and compliance with IFRSs
‰ Going concern
‰ Accrual basis of accounting
‰ Materiality and aggregation
‰ Offsetting
‰ Frequency of reporting
‰ Comparative information
‰ Consistency of presentation
2.2 Fair presentation and compliance with IFRSs

Disclosure of compliance
An entity whose financial statements comply with IFRSs must make such
disclosure in the notes to the accounts.
Financial statements shall not be described as complying with IFRS unless they
comply with all the requirements of each applicable Standard and Interpretation.
Fair presentation
Financial statements must present fairly the financial position, financial
performance and cash flows of an entity.
This means that they must be a faithful representation of the effects of
transactions and other events in accordance with the definitions and recognition
criteria for assets, liabilities, income and expenses set out in IFRS.
The application of IFRSs, with additional disclosure when necessary, is
presumed to result in financial statements that achieve a fair presentation.

Financial reporting
Fair presentation requires:

‰ the selection and application of accounting policies in accordance with IAS
8, Accounting Policies, Changes in Accounting Estimates and Errors;
‰ the presentation of information, including accounting policies, in a manner
that provides relevant, reliable, comparable and understandable
information; and,
‰ the provision of additional disclosures when the particular requirements in
IFRSs are insufficient to enable users to understand the impact of particular
transactions or other events on the entity’s financial position and financial
performance.
‰
True and fair override
In extremely rare circumstances, management might conclude that compliance
with a requirement in IFRS would be so misleading that it would conflict with the
objective of financial statements set out in IFRS.
In these cases the requirement should not be followed as longs as the relevant
regulatory framework requires or otherwise does not prohibit this.
When an entity departs from a requirement in IFRS it must disclose:
‰ that management has concluded that the financial statements present fairly
the entity’s financial position, financial performance and cashflows;
‰ that it has complied with applicable IFRS except that it has departed from a
particular requirement to achieve a fair presentation; and
x details of the departure:
x the Standard (or Interpretation) from which the entity has departed
and:
x the nature of the departure (including the treatment that is required by
IFRS);
x the reason why that treatment would be so misleading in the
circumstances that it would conflict with the objective of financial
statements set out in the “Framework”;
x the treatment adopted; and,
x for each period presented, the financial impact of the departure on
each item in the financial statements that would have been reported
in complying with the requirement.
If the relevant regulatory framework prohibits departure from a requirement the
entity must make the following disclosures to reduce the misleading aspects of
compliance “to the maximum extent possible”:
▪ the Standard (or Interpretation) requiring the entity to report information
concluded to be misleading and:
▪ the nature of the requirement;
▪ the reason why management has concluded that complying with that
requirement is so misleading in the circumstances that it conflicts with the
objective of financial statements; and,
▪ for each period presented, the adjustments to each item in the financial
statements that management has concluded would be necessary to
achieve a fair presentation.

2.3 Going concern

Financial statements must be prepared 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.
Management must assess an entity’s ability to continue as a going concern when
preparing financial statements.
In making this assessment management must take into account all available
information about the future. (This is for at least twelve months from the reporting
date).
Disclosures
If management is aware, in making its assessment, of material uncertainties
related to events or conditions that may cast significant doubt upon the entity’s
ability to continue as a going concern, those uncertainties must be disclosed.
If the financial statements are not prepared on a going concern basis, that fact
must be disclosed, together with:
‰ the basis on which the financial statements are prepared; and,
‰ the reason why the entity is not regarded as a going concern.
2.4 Accrual basis ofaccounting

Financial statements (except for cash flow information) must be prepared under
the accrual basis of accounting.
Under the accrual basis of accounting, items are recognised as assets, liabilities,
equity, income and expenses (the elements of financial statements) when they
satisfy the definitions and recognition criteria for those elements set out in the
“Framework”.
2.5 Materiality and aggregation

Each material class of similar items must be presented separately in the financial
statements.
Items of a dissimilar nature or function must be presented separately unless they
are immaterial.
An item that is not sufficiently material to warrant separate presentation on the
face of the financial statements may nevertheless be sufficiently material for it to
be presented separately in the notes.
Information is material if omitting, misstating or obscuring it could reasonably be
expected to influence the economic decisions of users taken on the basis of the
Materiality depends on the size and nature of the item or aggregation of items
judged in the particular circumstances of its omission.

Financial reporting
2.6 Offsetting
Assets and liabilities must not be offset except when offsetting is required by
another Standard.
The reporting of assets net of valuation allowances - for example, obsolescence
allowances on inventories and doubtful debts allowances on receivables - is not
offsetting.
Items of income and expense must be offset when, and only when IFRS requires
or permits it. For example:
▪ gains and losses on the disposal of non-current assets are reported by
deducting from the proceeds on disposal the carrying amount of the asset
and related selling expenses; and,
▪ expenditure that is reimbursed under a contractual arrangement with a third
party (for example, a subletting agreement) is netted against the related
reimbursement.
Also gains and losses arising from a group of similar transactions are reported on
a net basis (for example, foreign exchange gains and losses or gains and losses
arising on financial instruments held for trading purposes).
Such gains and losses must be reported separately if their size, nature or
incidence is such that separate disclosure is necessary for an understanding of
financial performance.
2.7 Frequency of reporting

Financial statements must be presented at least annually.
When an entity’s reporting date changes its financial statements are presented
for a period longer or shorter than one year. In such cases an entity must
disclose, in addition to the period covered by the financial statements:
▪ the reason for using a period other than one year; and,
▪ the fact that comparative amounts for the income statement, changes in
equity, cash flows and related notes are not comparable.
2.8 Comparative information

Comparative information must be disclosed in respect of the previous period for
all amounts reported in the financial statements unless IFRS permits or requires
otherwise.
Comparative information must be included for narrative and descriptive
information when it is relevant to an understanding of the current period’s
When the presentation or classification of items in the financial statements is
amended, comparative amounts must be reclassified (unless the reclassification
is impracticable). When comparative amounts are reclassified, an entity must
disclose:
• the nature of there classification;
• the amount of each item or class of items that is reclassified; and,
• the reason for the reclassification.

The following must be disclosed when reclassification of comparative amounts is

impracticable:
• the reason for not reclassifying the amounts; and,
• the nature of the adjustments that would have been made if the amounts
were reclassified.
2.9 Consistency of presentation

The presentation and classification of items in the financial statements must be
retained from one period to the next unless:
‰ a significant change in the nature of the operations of the entity or a review
of its financial statement presentation demonstrates that a change in
presentation results in a more appropriate presentation of transactions or
other events; or a change in presentation is required by an IFRS.
3 STRUCTURE AND CONTENT OF THE STATEMENT OF FINANCIAL

POSITION
Introduction
Current and non-current assets and liabilities
Current assets
Current liabilities
Information to be presented on the face of the statement of financial position
3.1 Introduction
IFRS uses terms which are incorporated into this study text. However, it does not
forbid the use of other terms and you might see other terms used in practice.
IAS 1 sets out the requirements for information that must be presented in the
statement of financial position or in notes to the financial statements, and it also
provides implementation guidance. This guidance includes an illustrative format
for a statement of financial position. This format is not mandatory but you should
learn it and use it wherever possible.
3.2 Current and non-current assets and liabilities

Current and non-current items should normally be presented separately in the
statement of financial position, so that:
current and non-current assets are divided into separate classifications; and
current and non-current liabilities are also classified separately.
As a general rule, an amount is ‘current’ if it is expected to be recovered or
settled no more than 12 months after the end of the reporting period.

3.3 Current assets
IAS 1 states that an asset should be classified as a current asset if it satisfies
any of the following criteria:
▪ The entity expects to realise the asset, or sell or consume it, in its normal
operating cycle.
▪ The asset is held for trading purposes.
▪ The entity expects to realise the asset within 12 months after the reporting
period.
▪ It is cash or a cash equivalent unless the asset is restricted from being
used for at least 12 months after the reporting date. (Note: An example of
‘cash’ is money in a current bank account. An example of a ‘cash
equivalent’ is money held in a term deposit account with a bank.)
All other assets should be classified as non-current assets.
This definition allows inventory or trade receivables to qualify as current assets,
even if they may not be realised into cash within 12 months, provided that they
will be realised in the entity’s normal operating cycle or trading cycle.
The operating cycle of an entity is the time between the acquisition of assets for
processing and their realisation in cash or cash equivalents. When the entity's
normal operating cycle is not clearly identifiable, it is assumed to be twelve
months. This is almost always the case.
3.4 Current liabilities

IAS 1 also states that a liability should be classified as a current liability if it
satisfies any of the following criteria:
‰ The entity expects to settle the liability in its normal operating cycle.
‰ The liability is held primarily for the purpose of trading. This means that all
trade payables are current liabilities, even if settlement is not due for over
12 months after the end of the reporting period.
‰ It is due to be settled within 12 months after the end of the reporting period.
‰ The entity does not have the unconditional right to defer settlement of the
liability for at least 12 months after the end of the reporting period.
All other liabilities should be classified as non-current liabilities.
3.5 Information to be presented on the face of the statement of

financial position
IAS 1 provides a list of items that, as a minimum, must be shown on the face of
the statement of financial position as a ‘line item’ (in other words, on a separate
line in the statement):
Assets
(a) Property, plant and equipment
(b) Investment property
(c) Intangible assets
(d) Long-term financial assets, such as long-term holdings of shares in other
companies, with the exception of item (e) below
(e) Investments accounted for using the equity method (this is explained in a
later chapter on investments in associates)
(f) Biological assets

(g) Inventories
(h) Trade and other receivables
(i) Cash and cash equivalents.
(j) The total of assets classified as held for sale in accordance with IFRS5
Liabilities
(k) Trade and other payables
(l) Provisions
(m) Financial liabilities, excluding any items in (k) and (l) above: (for example,
bank loans)
(n) Liabilities (but possibly assets) for current tax, as required by IAS12:
Income Taxes
(o) Deferred tax liabilities (but possibly assets). These are always non-current.
(p) Liabilities included in disposal groups in accordance with IFRS5

Equity
(q) Non-controlling interests presented within equity
(r) Issued capital and reserves attributable to the owners of the entity. (The
term ‘owners’, refers to the equity holders.)
Additional line items should be included in the statement of financial position

when presenting them separately and is ‘relevant to an understanding of the
entity’s financial position.
Information to be shown on the face of the statement of financial

positionorin notes
Some of the line items in the statement of financial position should be sub-
classified into different categories, giving details of how the total figure is made
up. This sub-classification may be presented either:
as additional lines on the face of the statement of financial position (adding up to
the total amount for the item as a whole) or
in notes to the financial statements. For
example:
‰ Tangible non-current assets should be divided into sub-categories, as
required by IAS 16: Property, Plant and Equipment.
‰ Receivables should be sub-classified into trade receivables, receivables
from related parties, prepayments and other amounts.
‰ Inventories are sub-classified in accordance with IAS 2: Inventories into
categories such as merchandise, materials, work-in-progress and finished
goods.

Example: statement of financial position of an individual entity

IAS 1 does not specify what the exact format of the statement of financial position
should be. However, it includes an illustrative statement of financial position in
Guidance to implementing the Standard (which is an appendix to the Standard).
The example below is based on that example. Illustrative figures are included.
Statement of financial position of ABCD Entity as at 31 December 20XX
N m N m
Assets
Non-current assets
Property, plant and equipment 205.1
Intangible assets 10.7
Investments 6.8
Current assets ––––––– 222.6
Inventories 17.8
Trade and other receivables 13.3
Other current assets 2.0
Cash and cash equivalents 0.7
––––––– 33.8
–––––––
Total assets 256.4
–––––––
Equity and liabilities

Share capital 50.0
Retained earnings (accumulated profits) 60.6
Other components of equity 31.9
––––––
Total equity 142.5
Non-current liabilities
Long-term borrowings 30.0
Deferred tax 4.5
––––––
Total non-current liabilities 34.5
––––––
Current liabilities
Trade and other payables 67.1
Short-term borrowings (bank overdraft) 3.2
Current portion of long-term borrowing 5.0
Current tax payable 4.1
––––––
Total current liabilities 79.4
––––––
Total liabilities 113.9
–––––––
Total equity and liabilities 256.4
–––––––

Financial reporting
4 STRUCTURE AND CONTENT OF THE STATEMENT OF PROFIT OR

LOSS AND OTHER COMPREHENSIVE INCOME
A single statement or two statements

Information to be presented on the face of the statement of profit or loss and
other comprehensive income
Analysis of expenses by their function
Analysis of expenses by their nature
4.1 A single statement or two statements

The statement of profit or loss and other comprehensive income provides
information about the performance of an entity in a period. It consists of two
parts:
▪ a statement of profit or loss – a list of income and expenses which result in
a profit or loss for the period; and
▪ a statement of other comprehensive income – a list of other gains and
losses that have arisen in theperiod.
IAS 1 allows an entity to present the two sections in a single statement or in two
separate statements. If two separate statements are used, they should include all
the information that would otherwise be included in the single statement of profit
or loss and other comprehensive income.
The statement of profit or loss shows the components of profit or loss, beginning
with ‘Revenue’ and ending with ‘Profit (or Loss)’ for the period after tax.
Examples of other comprehensive income

In this syllabus the only gains and losses that are recognised in the statement of
other comprehensive income are those arising on the revaluation of property.
plant and equipment under the rules in IAS 16. This is covered in more detail in
chapter 7 of this text.
There are many other transactions which must be recognised in the statement of
other comprehensive income but these are not in the scope of this syllabus. You
will study them in papers at a higher level.
Definition of total comprehensive income

Total comprehensive income during a period is the sum of:
‰ the profit or loss for the period; and
‰ other comprehensive income.

4.2 Information to be presented on the face of the statement of profit or loss

and other comprehensive income
As a minimum, IAS 1 requires that the statement of profit or loss and other
comprehensive income should include line items showing the following amounts
for the financial period:
(a) revenue
(b) finance costs (for example, interest costs)
(c) share of profit of associates
(d) taxexpense
(e) an amount related to the profit or loss from discontinued operations (IFRS5)
(f) profit or loss
(g) each component of ‘other comprehensive income
(h) total comprehensive income.
Additional line items should be presented on the face of the statement of profit
or loss and other comprehensive income when it is relevant to an understanding
of the entity’s financial performance.
Example: Statement of profit or loss and other comprehensive income of

an individual entity
IAS 1 does not specify formats.
The example below is based on a suggested presentation included in the
implementation guidance to IAS 1.
ended 31 December 20XX

N
678
Revenue
Cost of sales 250
–––––
Gross profit 428
Other income 44
Distribution costs (98)
Administrative expenses (61)
Other expenses (18)
Finance costs (24)
–––––
Profit before tax 271
Taxation (50)
–––––
PROFIT FOR THE YEAR 221
Other comprehensive income
Gains on property 46
–––––
revaluation –––––
TOTAL COMPREHENSIVE INCOME FOR THE YEAR 267

Financial reporting
Information to be shown on the face of the statement of profit or loss and

other comprehensive income (or the statement of profit or loss, if separate)
or in the notes
The following information may be shown either on the face of the statement of
profit or loss or in a note to the financial statements:
‰ material items of income and expense
‰ an analysis of expenses, providing either:
x expenses analysed by their nature, or
x expenses analysed by the function that has incurred them.
IAS 1 encourages entities to show this analysis of expenses on the face of the
statement of profit or loss, rather than in a note to the accounts.
Material items that might be disclosed separately include:
‰ a write-down of inventories from cost to net realisable value, or a write-
down of items of property, plant and equipment to recoverable amount
‰ the cost of a restructuring of activities
‰ disposals of items of property, plant and equipment
‰ discontinued operations
‰ litigation settlements
‰ a reversal of a provision.
4.3 Analysis of expenses by their function

When expenses are analysed according to their function, the functions are
commonly ‘cost of sales’, ‘distribution costs’, ‘administrative expenses’ and ‘other
expenses’. This method of analysis is also called the ‘cost of sales method’.

In practice, most entities use this method.
An example of a statement of profit or loss, showing expenses by function (cost
of sales, distribution costs, administrative expenses) is as follows.
The following is an extract from the accounts of Entity Red for the year to 30
June 20X5, after the year-end adjustments had been made:
Debit Credit
N000 N000
Cost of sales 6,214
Distribution costs 3,693
Revenue 14,823
Other expenses 248
Administrative expenses 3,901
Other income 22
Required
Show the first part of Entity Red’s statement of profit or loss using the ‘cost of
sales’ analysis method.
Entity Red: Statement of profit or loss for the year ended 30 June 20X5
N
Revenue 14,823
Cost of sales 6,214
Gross profiit 8,609
Other income 22
Distribution costs (3,693)
Administrative expenses (3,901)
Other expenses (248)
The basis for separating these costs between the functions would be given in the
question.
4.4 Analysis of expenses by their nature

When expenses are analysed according to their nature, the categories of
expenses will vary according to the nature of the business.
In a manufacturing business, expenses would probably be classified as:
▪ raw materials and consumablesused;
▪ staff costs (‘employee benefits costs’);and
▪ depreciation.
Items of expense that on their own are immaterial are presented as ‘other
expenses’.
There will also be an adjustment for the increase or decrease in inventories of
finished goods and work-in-progress during the period.
Other entities (non-manufacturing entities) may present other expenses that are
material to their business.

An example of a statement of profit or loss, showing expenses by their nature, is
shown below, with illustrative figures included.
Example: Analysis of expenses by nature

The following is an alternative method of presenting the accounts of Entity Red.
N 000
Increase in inventories of finished goods and work-in-progress 86
Revenue 14,823
Raw materials and consumables 5,565
Depreciation 1,533
Other income 22
Staff costs 4,926
Other operating expenses 2,118
Required
Show the first part of Entity Red’s statement of profit or loss using the ‘nature of
expenditure’ method, down to the operating profit level.
Entity Red: Statement of profit or loss for the year ended 30 June 20X5
N 000 N 000
Revenue 14,823
Otherincome 22
–––––
14,845
Changes in inventories of finished goods and work-
inprogress (reduction=expense,increase=negative
expense) (86)
Raw materials and consumables used 5,565
Staff costs (employee benefits costs) 4,926
Depreciation and a mortisation expense 1,533
Other operating expenses 2,118
–––– 14,056
–––––
–––––

5 STATEMENT OF CHANGES IN EQUITY (SOCIE)
The contents of a statement of changes inequity

Retrospective adjustments
5.1 The contents of a statement of changes in equity

A set of financial statements must include a statement of changes in equity
(SOCIE).
A SOCIE shows for each component of equity the amount at the beginning of the
period, changes during the period, and its amount at the end of the period.
Components of equity include:
▪ Share capital;
▪ Share premium;
▪ Retained earnings;
▪ Revaluation surplus.
In a SOCIE for a group of companies, the amounts attributable to owners of the
parent entity and the amounts attributable to the non-controlling interest should
be shown separately. (Non-controlling interest is a concept used in group
accounts. This is covered in a later chapter).
For each component of equity, the SOCIE should show changes resulting from:
▪ profit or loss for the period;
▪ each item of other comprehensive income;
▪ transactions with owners in their capacity as owners.
Transactions with owners in their capacity as owners
These include:
▪ new issues of shares;
▪ payments of dividends;
▪ repurchases and cancellation of its own shares by the company.
These transactions are not gains or losses, so are not shown in the statement of
comprehensive income but they do affect equity. The SOCIE highlights such
transactions.

Financial reporting
5.2 Retrospective adjustments

IAS8 Accounting policies, changes in accounting estimates and errors
requires that when an entity changes an accounting policy or restates amounts in
the financial statements to correct errors, the adjustments should be made
retrospectively (to the extent that this is practicable).
Retrospective adjustments result in changes in the reported amount of an equity
component, usually retained earnings. Retrospective adjustments and re-
statements are not changes in equity, but they are adjustments to the opening
balance of retained earnings (or other component of equity).
Where retrospective adjustments are made, the SOCIE must show for each
component of equity (usually retained earnings) the effect of the retrospective
adjustment. This is shown first, as an adjustment to the opening balance, before
the changes in equity are reported. (This is covered in more detail in chapter 4).
Illustration: statement of changes in equity
Share Share General Accumulated

capital premium reserve profits Total
Nm Nm Nm Nm Nm
Balance at 31
December 20X8 200 70 80 510 860
Change in accounting
policy - - - (60) (60)
Restated balance 200 70 80 450 800
Changes in equity for
20X9
Issue of share capital 80 100 180
Dividend payments (90) (90)
Profit for the year 155 155
Other comprehensive 12
income for the year 12
Balance at 31
December 20X9 280 170 92 515 1,057
The statement reconciles the balance at the beginning of the period to that at
the end of the period for each component of equity.

6 NOTES TO THE FINANCIAL STATEMENTS
Section overview
„ Introduction
„ Structure
„ Disclosure of accounting policies
„ Other disclosures
6.1 Introduction
Notes contain information in addition to that presented in the statement of
financial position, statement of profit or loss and other comprehensive income,
statement of changes in equity and statement of cash flows.
Notes provide narrative descriptions of items in those statements and information
about items that do not qualify for recognition in those statements. They also
explain how totals in those statements are formed.
6.2 Structure
The notes to the financial statements of an entity must:
▪ present information about the basis of preparation of the financial
statements and the specific accounting policies selected and applied for
significant transactions and other significant events;
▪ disclose the information required by IFRSs that is not presented elsewhere
in the financial statements; and
▪ provide additional information that is not presented on the face of the
financial statements but is relevant to an understanding of them.
Notes to the financial statements must be presented in a systematic manner. Each
item on the face of the statement of financial position, statement of profit or loss
and other comprehensive income, statement of changes in equity and statement
of cash flows must be cross-referenced to any related information in the notes.
Notes are normally presented in the following order:
‰ a statement of compliance with IFRS;
‰ a summary of significant accounting policie sapplied;
‰ supporting information for items presented on the face of each financial
statement in the order in which each financial statement and each line item
is presented; and
‰ other disclosures, including:
x contingencies;
x un-contracted commitments; and
x non-financial disclosures.

Financial reporting
6.3 Disclosure of accounting policies

An entity must disclose the following in the summary of significant accounting
policies:
‰ the measurement basis (or bases) used in preparing the financial
statements; and
‰ the other accounting policies used that are relevant to an understanding of
the financial statements.
‰ the judgements (apart from those involving estimations) made by
management in applying the accounting policies that have the most
significant effect on the amounts of items recognised in the financial
statements. For example:
x whether, in substance, particular sales of goods are financing
arrangements and therefore do not give rise to revenue; and
x whether the contractual terms of financial assets give rise on
specified dates to cash flows that are solely payments of principle and
interest.
Which policies?
Management must disclose those policies that would assist users in
understanding how transactions, other events and conditions are reflected in the
reported financial performance and financial position.
If an IFRS allows a choice of policy, disclosure of the policy selected is especially
useful.
Some standards specifically require disclosure of particular accounting policies.
For example, IAS 16 requires disclosure of the measurement bases used for
classes of property, plant and equipment.
It is also appropriate to disclose an accounting policy not specifically required by
IFRSs but selected and applied in accordance with IAS 8. (See chapter 4).
Key measurement assumptions

An entity must disclose information regarding key assumptions about the future,
and other key sources of measurement uncertainty, that have a significant risk of
causing a material adjustment to the carrying amounts of assets and liabilities
within the next financial year.
In respect of those assets and liabilities, the notes must include details of:
‰ their nature; and
‰ their carrying amount as at the reporting date.
Examples of key assumptions disclosed are:
‰ future interest rates;
‰ future changes in salaries;
‰ future changes in prices affecting other costs; and,
‰ useful lives.

Examples of the types of disclosures made are:

▪ the nature of the assumption or other measurement uncertainty;
• the sensitivity of carrying amounts to the methods, assumptions
and estimates underlying their calculation, including the reasons
for the sensitivity;
• the expected resolution of an uncertainty and the range of reasonably
possible outcomes within the next financial year in respect of the
carrying amounts of the assets and liabilities affected; and
• an explanation of changes made to past assumptions concerning
those assets and liabilities, if the uncertainty remains unresolved.
6.4 Other disclosures

An entity must disclose in the notes:
▪ the amount of dividends proposed or declared before the financial
statements were authorised for issue but not recognised as a distribution to
owners during the period, and the related amount per share; and
▪ the amount of any cumulative preference dividends not recognised.
▪ An entity must disclose the following, if not disclosed elsewhere in
information published with the financial statements:
▪ the domicile and legal form of the entity;
▪ a description of the nature of the entity’s operations and its principal
activities; and
▪ the name of the parent and the ultimate parent of the group.

Financial reporting
7 FINANCIAL STATEMENT – SPECIMEN FORMATS
Statement of comprehensive income (analysis of expenses by function)

Statement of financial position
IAS 1 does not specify formats for financial statements. However, it includes
illustrative statements in an appendix to the Standard).
The illustrations below are based on the illustrative examples.
7.1 Statement of comprehensive income (analysis of expenses by function)
Statement of comprehensive income for the year ended 31

December 20 X 9
N
Revenue X
Cost of sales (X)
Gross profit X
Other income X
Distribution costs (X)
Administrative expenses (X)
Other expenses (X)
Finance costs (X)
Share of profit of associates
Profit before tax X
Taxation (X)
PROFIT FOR THE YEAR X
Gains on property revaluation X
OTHER COMPREHENSIVE INCOME FOR THE YEAR X
TOTAL COMPREHENSIVE INCOME FOR THE YEAR X

7.2 Statement of financial position
Illustration: Statement of financial position format

Statement of financial position as at 31 December 20 X 9
N N
Property, plant and equipment X

Goodwill X
Intangible assets X
Investments in associates X
Available for sale financial assets X
Total non-current assets X
Current assets
Inventories X
Trade receivables X
Other current assets X
Cash and cash equivalents X
Total current assets X
Total assets X

Equity attributable to owners of the parent
Share capital X
Share premium(notmentionedinIAS1bu tincluded
fo rcompleteness)
Retained earnings X
Other components of equity X
X
Non-controlling interest X
Total equity X
Long-term borrowings X
Deferred tax X
Long term provisions X
Total non-current liabilities X
Current liabilities
Trade and other payables X
Short-term borrowings X
Current portion of long-term borrowing X
Current tax payable X
Short term provisions X
Total current liabilities X
Total liabilities X
Total equity and liabilities X

Financial reporting
8 TECHNIQUE OF PREPARING FINANCIAL STATEMENTS
Introduction
Preparation of financial statements: Approach 1
Preparation of financial statements: Approach 2
8.1 Introduction
In this exam you will be expected to prepare a statement of financial position and
statement of profit or loss and other comprehensive income from a trial balance.
These questions are usually quite time pressured so you need to develop a good
technique in order to complete such tasks in an effective way.
The rest of this chapter use the following example to illustrate how such
questions might be approached. You will need to choose an approach and
practice it.
The example includes several straightforward year-end adjustments for
illustrative purposes. In the exam you will face more complicated adjustments
than these.
Example:
ABC – Trial balance as at 31 December 20X9
N N
Revenue 428,000
Purchases 304,400
Wages and salaries 64,000
Rent 14,000
Lighting and cooling 5,000
Inventory as at 1 January 20X9 15,000
Drawings 22,000
Allowance for doubtful debts 4,000
Non-current assets 146,000
Accumulated depreciation: 32,000
Trade receivables 51,000
Trade payables 42,000
Cash 6,200
Capital as at 1 January 20X9 121,600
627,600 627,600
Further information:.

Financial reporting
The journals
The business needs to process the following double entries to take account of
the “further information” given above.
a)
Lighting and cooling expenses 400
Accrual 400
Being: Accrual for lighting and cooling expenses
b) Rent prepayment
Prepayment 700
Rent expense 700
Being: Adjustment to account for rent prepayment
c) Bad and doubtfuldebt

Bad and doubtful debt expense 1,200
Receivables 1,200
Being: Write off of bad debt
Bad and doubtful debt expense 500

Allowance for doubtfuldebts 500
Being: Increase in the allowance for doubtful debts
d) Depreciation
Depreciation expense 14,600
Accumulated depreciation 14,600
Being: Depreciation for the year (10% of 146,000)
e) Closing inventory
Inventory (asset) 16,500
Inventory (cost of sales) 16,500
Being: Recognition of inventory at the year-end
These journals are only given to explain the double entry required. You should
never write something like this in a preparation of financial statements question. It
uses up too much time. You want to do double entry rather than write journals.
The chapter continues to show two possible approaches that you might follow.
You do not have to do either. If you decide on a way that suits you then use it.
If you attend courses your lecture will show you how to do this. They are very
experienced. Do as they advise.

8.2 Preparation of financial statements: Approach 1

Step 1: Perform double entry on the face of the question and open up new
accounts as you need them in any space that you have. (DO NOT COPY OUT
THE TRIAL BALANCE).
After this your question paper should look something like the following (with the
double entries are shown in bold italics):
Example: ABC – Trial balance as at 31 December 20X9

N N
Revenue 428,000
Purchases 304,400
Rent 14,000 700b
Lighting and cooling 5,000 + 400a
Inventory as at 1 January 20X9 15,000
Drawings 22,000
Allowance for doubtful debts 4,000+ 500c
Accumulated depreciation: 32,000+

14,600d
Trade receivables 51,000 1,200c

Cash 6,200
Capital as at 1 January 20X9 121,600
627,600 627,600
Accruals 400a
Prepayments 700b
Bad and doubtful debt expense 1200c + 500c
Depreciation expense 14,600d
Closing inventory (asset) 16,500e
Closing inventory (cost of sales) 16,500e
Step 2: Draft pro-forma financial statements including all of the accounts that you
have identified. (A pro-forma is a skeleton document into which you can copy
numbers later)
Step 3: Copy the numbers from the trial balance into the pro-forma statements.
Note that if a number copied onto the financial statements is made up of a
number provided in the original trial balance that has been adjusted, you must
show the marker what you have done. This may involve adding in an additional
explanation below the main answer or may be shown on the face of the
statements.

Financial reporting
Step 4: Calculate profit for the year.

Step 5: Complete statement of financial position by adding profit to the opening
capital, deducting drawings to find the closing capital.
The final answer might look like this:
Example: ABC – Statement of financial position

N N
Assets
Non-current assets
Cost 146,000
Accumulated depreciation (32,000 + 14,600) (46,600)
99,400
Current assets
Inventories 16,500
Trade receivables (51,000 – 1,200) 49,800
Allowance for doubtful debts (4,000 + 500) (4,500)
45,300
Prepayments 700
Cash 6,200
68,700
Total assets 168,100

Capital
At start of year 121,600
Profit for the year 26,100
Drawings (22,000)
125,700
Current liabilities
Accruals (and prepaid income) 400
42,400
Total equity and liabilities 168,100

Example:ABC–Statement of comprehensive income (statement of profit or loss)

N N
Revenue 428,000
Cost of sales
Opening inventory 15,000
Purchases 304,400
319,400
Closing inventory (16,500)
(302,900)
Gross profit 125,100
Expenses:
Depreciation (W1) 14,600
Rent (14,000 – 700) 13,300
Lighting and cooling (5,000 + 400) 5,400
Bad and doubtful debts (1,200 + 500) 1,700
(99,000)
26,100
Workings
W1 – Depreciation: 10% of 146,000 = 14,600

Financial reporting
8.3 Preparation of financial statements: Approach 2

Step 1: Draft pro-forma financial statements including all of the accounts that you
have identified from reading the question. Leave spaces in case you have missed
an account that you might need to insert later.
Step 2: Copy the numbers from the trial balance into the pro-forma statements. If
you know that a number is not to be adjusted then you can copy it straight to its
destination. Otherwise set up bracketed workings next to the narrative in the pro-
forma.
After step 2 your answer might look like this:
Assets N N
Non-current assets
Cost 146,000
Accumulated depreciation (32,000
Current assets
Inventories
Trade receivables (51,000
Allowance for doubtful debts (4,000
Prepayments
Cash 6,200
Total assets

Capital
Profit for the year
Drawings (22,000)
Current liabilities
Accruals (and prepaid income)
Total equity and liabilities

N N
Revenue 428,000
Cost of sales
Purchases 304,400
319,400
Closing inventory
Gross profit
Expenses:
Depreciation
Rent (14,000
Lighting and cooling (5,000
Bad and doubtful debts

Financial reporting
Step 3: Perform double entry on the face of your answer.

Step 4: Complete the bracketed workings and copy totals into their final
destinations.
Step 5: Calculate profit for the year.
Step 6: Complete statement of financial position by adding profit to the opening
capital, deducting drawings to find the closing capital.
The final answer might look like this:

N N
Assets
Non-current assets
Cost 146,000
Accumulated depreciation (32,000 + 14,600) (46,600)
99,400
Current assets
Inventories 16,500
Trade receivables (51,000 – 1,200) 49,800
Allowance for doubtful debts (4,000 + 500) (4,500)
45,300
Prepayments 700
Cash 6,200
68,700

Capital
Profit for the year 26,100
Drawings (22,000)
125,700
Current liabilities
Accruals (and prepaid income) 400
42,400

Example:ABC–Statement of comprehensive income (statement of profit or loss)
N N
Revenue 428,000
Cost of sales
Purchases 304,400
319,400
(302,900)
Expenses:
Depreciation (W1) 14,600
Rent (14,000 – 700) 13,300
Lighting and cooling (5,000 + 400) 5,400
Bad and doubtful debts (1,200 + 500) 1,700
(99,000)
26,100
Workings
W1 – Depreciation: 10% of 146,000 = 14,600

Financial reporting
9 CHAPTER REVIEW
State the components of a set of financial statements according to IAS1
Explain the general features of financial statements described in IAS1
Define current and non-current assets
Define current and non-current liabilities
Explain the IAS 1 guidance on the structure of the statement of financial
position, the statement of profit or loss and other comprehensive income and
the statement of changes inequity
Describe the IAS 1 rules on notes to the financial statements

CHA PTER
Contents
Accounting policies
Accounting estimates
Errors
Chapter review

Financial reporting
INTRODUCTION
Aim
principles.
Detailed syllabus
a Discuss accounting policies and changes in accounting policies in
accordance with the provisions of IAS 8 – Accounting policies,
changes in accounting estimates and errors including calculation,
where necessary.
IAS 8 is an examinable document.
Exam context
This chapter explains the IAS 8 rules on the selection of accounting policies, accounting for
change in accounting policies and the use of accounting estimates and the correction of
errors.

„ Define accounting policy
„ Explain the guidance on the selection of accounting policies
„ Account for changes in accounting policy
„ Distinguish between accounting policy and accounting estimate
„ Account for changes in accounting estimates
„ Correct errors

Chapter 4: IAS 8: Accounting policies, changes in accounting estimates and errors
1 ACCOUNTING POLICIES
Introduction to IAS8
Accounting policies
Selection of accounting policies
Changes in accounting policies
Retrospective application of a change in accounting policy
Limitation on retrospective application
Disclosure of a change in accounting policy
1.1 Introduction to IAS8

The aim of IAS 8: Accounting policies, changes in accounting estimates and
errors is to enhance comparability of the entity’s financial statements to previous
periods and to the financial statements of other entities.
It does this by prescribing:
‰ the criteria for selecting accounting policies; and,
‰ the accounting treatment and disclosure of:
x changes in accounting policies;
x changes in accounting estimates; and
x errors.
Much of IAS 8 is concerned with how changes or corrections should be reported
in the financial statements.
1.2 Accounting policies
Definition: Accounting policies

Accounting policies are the specific principles, bases, conventions, rules and
practices applied by an entity in preparing and presenting financial statements.
IFRSs set out accounting policies that result in financial statements containing
relevant and reliable information about the transactions, other events and
conditions to which they apply. Those policies need not be applied when the
effect of applying them is immaterial.
Definition: Material
Information is material if omitting, misstating or obscuring it could reasonably be
expected to influence decisions that the primary users of general purpose financial
statements make on the basis of those financial statements, which provide
financial information about a specific reporting entity.
Materiality depends on the size and nature of the omission or misstatement

judged in the surrounding circumstances. The size or nature of the item, or a
combination of both, could be the determining factor

Financial reporting
1.3 Selection of accounting policies
Selection of accounting policies – Areas covered by IFRS

If an IFRS (or an Interpretation) applies to an item in the financial statements, the
accounting policy or policies applied to that item must be determined by applying
the Standard or Interpretation and any relevant implementation guidance issued.
Selection of accounting policies – Area not covered by IFRS

If there is no rule in IFRS that specifically applies to an item in the financial
statements, management must use its judgement to develop and apply an
accounting policy that results in information that is:
‰ relevant to the decision-making needs of users; and
‰ reliable in that the financial statements;
x represent faithfully the results and financial position of the entity;
x reflect the economic substance of transactions and other events and
not merely the legal form;
x are neutral, i.e. free from bias;
x are prudent; and
x are complete in all material respects.
In making the judgement management must consider the following sources in
descending order:
▪ the requirements and guidance in IFRS dealing with similar and related
issues;
▪ the definitions, recognition criteria and measurement concepts for assets,
liabilities, income and expenses set out in the “Framework”.
Management may also consider the most recent pronouncements of other
standard-setting bodies that use a similar conceptual framework to the extent that
these do not conflict with the above sources.
Consistency of accounting policies

An entity must apply consistent accounting policies in a period to deal with similar
transactions, and other events and circumstances, unless IFRS specifically
requires or permits categorisation of items for which different policies may be
appropriate.
Illustration: Consistency
IAS 16: Property, plant and equipment allows the use of the cost model or the
revaluation model for measurement after recognition.
This is an example of where IFRS permits categorisation of items for which
different policies may be appropriate.
If chosen, each model must be applied to an entire class of assets. Each model
must be applied consistently within each class that has been identified.

1.4 Changes in accounting policies

Users of financial statements need to be able to compare financial statements of
an entity over time, so that they can identify trends in its financial performance or
financial position. Frequent changes in accounting policies are therefore
undesirable because they make comparisons with previous periods more difficult.
The same accounting policies must be applied within each period and from one
period to the next unless a change in accounting policy meets one of the
following criteria. A change in accounting policy is permitted only if the changeis:
▪ required by IFRS; or
▪ results in the financial statements providing reliable and more relevant
financial information.
A new or revised standard usually include specific transitional provisions to
explain how the change required by the new rules should be introduced.
In the absence of specific transitional provisions, a change in policy should be
applied retrospectively. This is explained shortly.
Determining when there is a change in accounting policy

A change in accounting policy can be established as follows. The accounting
policies chosen by an entity should reflect transactions and events through:
– recognition (e.g., capitalising or writing off certain types ofexpenditure)
– measurement (e.g., measuring non-current assets at cost orvaluation)
– presentation (e.g., classification of costs as cost of sales or administrative
expenses)
If at least one of these criteria is changed, then there is a change in accounting
policy.
Illustration: Determining when there is a change in accounting policy

X Ltd has previously used the cost model to measure investment properties (IAS
40).
X Ltd decides to use the fair value model instead because it is believed that this
will provide reliable and more relevant information.
This is a change in accounting policy affecting measurement.
IAS 8 specifies that the application of a new accounting policy to transactions or

events that did not occur previously or differ in substance from those that
occurred previously, is not a change of accounting policy. It is simply the
application of a suitable accounting policy to a new type of transaction.
The initial application of a policy to revalue assets in accordance with IAS 16
Property, Plant and Equipment or IAS 38 Intangible Assets is a change in an
accounting policy. However, it is accounted for in accordance with the guidance
in those standards rather than in accordance with IAS 8.

Financial reporting
1.5 Retrospective application of a change in accounting policy

When a change in accounting policy is required, and there are no transitional
provisions relating to the introduction of a new accounting standard, the change
in policy should be applied retrospectively.
Definition: Retrospective application

Retrospective application is applying a new accounting policy to transactions,
other events and conditions as if that policy had always been applied.
The entity should adjust the opening balance for each item of equity affected by
the change, for the earliest prior period presented, and the other comparative
amounts for each prior period presented, as if the new accounting policy had
always been applied.
IAS 1: Presentation of Financial Statements requires a statement of financial
position at the beginning of the earliest comparative period when a new
accounting policy is applied retrospectively.
Illustration: Retrospective application

A company presents comparatives for the previous year only.
During the year ended 31 December 20 X 9 it changes an accounting policy and
this change must be applied retrospectively.
If there were no change in accounting policy the company would present
statements of financial position as at December 20 X 9 and December 20 X 8
only.
However, because there is a change in policy the company must also present a
statement of financial position as at 1 January 20 X 8 (the beginning of the earliest
comparative period).
The change in accounting policy is applied retrospectively. This means that the
change should be applied to the balances at as at 1 January 20X8 as if the new
policy had always been applied.
Similarly, any other comparative amounts in previous periods should be adjusted
as if the new accounting policy had always been applied.
If this is impracticable, retrospective application should be applied from the

earliest date that is practicable.

1.6 Limitation on retrospective application

It might be impracticable to retrospectively apply an accounting policy. This could
be because the information necessary for the application of the policy to earlier
periods is not available because it had not been collected then.
Definition: Impracticable
Applying a requirement is impracticable when the entity cannot apply it after
making every reasonable effort to do so. For a particular prior period, it is
impracticable to apply a change in an accounting policy retrospectively or to make
a retrospective restatement to correct an errorif:
(a) the effects of the retrospective application or retrospective restatement are
not determinable;
(b) the retrospective application or retrospective restatement requires
assumptions about what management's intent would have been in that
period;or
(c) the retrospective application or retrospective restatement requires
significant estimates of amounts and it is impossible to distinguish
objectively information about those estimates that:
(i) provides evidence of circumstances that existed on the date(s) as at
which those amounts are to be recognised, measured or disclosed;
and
(ii) would have been available when the financial statements for that prior
period were authorized for issue from other information.
There are different degrees of impracticability.
Period specific effect

It might be impracticable to determine the effect of changing an accounting policy
on comparative information for one or more prior periods presented. For example,
it might be impracticable to determine the impact on profit for the prior year.
In this case a company must apply the new accounting policy to the carrying
amounts of assets and liabilities (and therefore equity) as at the beginning of the
earliest period for which retrospective application is practicable. This may be the
current period.
Cumulative effect
It might be impracticable to determine the cumulative effect, at the beginning of
the current period, of applying a new accounting policy to all prior periods,
In this case a company must adjust the comparative information to apply the new
accounting policy prospectively from the earliest date practicable.
When the cumulative effect of applying the policy to all prior periods cannot be
determined, a company must apply the new policy prospectively from the start of
the earliest period practicable. This means that it would disregard the portion of
the cumulative adjustment to assets, liabilities and equity arising before that date.

Financial reporting
Definition: Prospective application

Prospective application of a change in accounting policy and of recognising the effect
of a change in an accounting estimate, respectively, are:
(a) applying the new accounting policy to transactions, other events and
conditions occurring after the date as at which the policy is changed; and
(b) recognising the effect of the change in the accounting estimate in the current
and future periods affected by the change.
1.7 Disclosure of a change in accounting policy

When a change in accounting policy has an effect on the current period or any
prior period (or would have an effect that period, except that it is impracticable to
determine the amount of the adjustment) or might have an effect on future periods
the following must be disclosed:
Disclosure: Change due Voluntary

to IFRS change
The title of the Standard or Interpretation 9
The nature of the change in accounting policy 9 9
A description of any transitional provisions 9
The reason why the new accounting policy
9
provides reliable and more relevant information
For the current and previous period(s), to the
extent practicable, the amount of the adjustment 9 9
to each item in the financial statements.
To the extent practicable, the adjustment
relating to accounting periods before those 9 9
presented in the financial statements
If retrospective application is impracticable, an
explanation of how the accounting policy change 9 9
has been applied

2 ACCOUNTING ESTIMATES
Accounting estimates
Changes in accounting estimates
Disclosures
2.1 Accounting estimates

An accounting estimate is made for an item in the financial statements when the
item cannot be measured with precision, and there is some uncertainty about it.
An estimate is therefore based, to some extent, on management’s judgement.
Management estimates might be required, for example, for the following items:
▪ Bad debts;
▪ inventory obsolescence;
▪ the fair value of financial assets or liabilities;
▪ the useful lives of non-current assets;
▪ the most appropriate depreciation pattern (depreciation method, for
example straight line or reducing balance) for a category of non-current
assets;
▪ measurement of warrantyprovisions.
The use of reasonable estimates is an essential part of the preparation of
financial statements and does not undermine their reliability.
Accounting policy vs accounting estimate

Sometimes it can be difficult to distinguish between changes in accounting policy
from changes in accounting estimate. In such cases any change is treated as a
change in accounting estimate.
Illustration: Accounting policy vs accounting estimate

Accounting policy: Depreciating plant and equipment over its useful life
Accounting estimate: How to apply the policy. For example whether to use the
straight line method of depreciation or the reducing balance methodis a choice of
accounting estimate.
A change in the measurement basis applied is a change in an accounting policy,

and is not a change in an accounting estimate.
Illustration: Accounting policy vs accounting estimate

IAS 16: Property, plant and equipment allows the use of the cost model or the
revaluation model for measurement after recognition.
This is a choice of accounting policy.

Financial reporting
2.2 Changes in accounting estimates
Definition: Change in accounting estimate

A change in accounting estimate is an adjustment of the carrying amount of an
asset or a liability, or the amount of the periodic consumption of an asset, that
results from the assess mentof the present status of, and expected future benefits
and obligations associated with, assets and liabilities. Changes in accounting
estimates result from new information or new developments and, accordingly, are
not corrections of errors.
A change in accounting estimate may be needed if changes occur in the

circumstances on which the estimate was based, or if new information becomes
available. A change in estimate is not the result of discovering an error in the way
an item has been accounted for in the past and it is not a correction of an error.
Prospective application of a change in estimate

A change in accounting estimate is accounted for prospectively not
retrospectively. This means that the effect of the change is recognised in the
current period and the future periods affected by the change.
The effect of a change in accounting estimate should be recognised
prospectively, by including it:
– in profit or loss for the period in which the change is made, if the change
affects that period only, or
– in profit or loss for the period of change and future periods, if the change
affects both.
To the extent that a change in estimate results in a change in assets and liabilities,
it should be recognised by adjusting the carrying amount of the affected assets or
liabilities in the period of change.
Example: Change in accounting estimate

A non-current asset was purchased for N200,000 two years ago, when its expected
economic life was ten years and its expected residual value was nil. The asset
is being depreciated by the straight-line method.
A review of the non-current assets at the end of year 2 revealed that due to
technological change, the useful life of the asset is only six years in total, and the
asset therefore has a remaining useful life of four years.
The original depreciation charge was N20,000 per year(N200,000/10years) and at the
beginning of Year 2, its carrying value was N180,000 (N200,000 - N20,000).
The change in the estimate occurs in Year 2. The change in estimate should be
applied prospectively, for years 2 onwards (years 2 – 6). From the beginning of
year 2, the asset has a revised useful remaining life of five years.
The annual charge for depreciation for year 2 (the current year) and for the
future years 3 – 6 will be changed from N20,000 to N36,000 (N180,000/5years).

2.3 Disclosures
The following information must be disclosed:
– The nature and amount of a change in an accounting estimate that has an
effect in the current period or is expected to have an effect in future periods,
except for the effect on future periods when it is impracticable to estimate
that effect.
– The fact that the effect in future periods is not disclosed because estimating
it is impracticable (if this is the case).
3 ERRORS
Errors
The correction of prior period errors
Limitation on retrospective restatement
Disclosure of prior period errors
3.1 Errors
Errors might happen in preparing financial statements. If they are discovered
quickly, they are corrected before the finalised financial statements are published.
When this happens, the correction of the error is of no significance for the purpose
of financial reporting.
A problem arises, however, when an error is discovered that relates to a prior
accounting period or if after the financial statements have been published. For
example, in preparing the financial statements for Year 3, an error may be
discovered affecting the financial statements for Year 2, or even Year 1.
Definition: Prior period errors

Prior period errors are omissions from, and misstatements in, the entity's financial
statements for one or more prior periods arising from a failure to use, or misuse
of, reliable information that:
(a) was available when financial statements for those periods were authorised
for issue; and
(b) could reasonably be expected to have been obtained and taken into account
in the preparation and presentation of those financial statements.
Such errors include the effects of mathematical mistakes, mistakes in applying
accounting policies, oversights or misinterpretations of facts, and fraud.
3.2 Correction of prior period errors

All material prior period errors should be corrected retrospectively in the first set
of financial statements following the discovery of the error.
Comparative amounts for the previous period should be re-stated at their
corrected amount.

If the error occurred before the previous year, the opening balances of assets,
liabilities and equity for the previous period should be re-stated at their corrected
amount unless that is impracticable.
The correction of a prior period error is excluded from profit or loss in the period
when the error was discovered.
Illustration: Correction of prior period errors

Inpreparing its financial statements for 31 December 20 X 9 Company a discovers
an error affecting the 31 December 20 X 8 financial statements.
The error should be corrected in the 31 December 20 X 9 financial statements
byre- stating the comparative figures for 31 December 20 X 8 at their correct
amount.
If the error had occurred in 31 December 20 X 7, the comparative opening
balances for the beginning of 31 December 20X8 should be re-stated at their
correct amount.
The reported profit for 31 December 20 X9 is not affected.

Example: Correction of prior period errors
Kano Transport Company (KTC) is preparing its financial statements for 20
X 9. The draft statement of changes in equity is as follows:
Share Share Retained
capital premium earnings Total
N000 N000 N000 N000

Balance at 31/12/X7 500 50 90 640
Profit for the year - - 150 150
Balance at 31/12/X8 500 50 240 790
20X9
Dividends (100) (100)
Balance at 31/12/X9 500 50 525 1,075
KTC has now discovered an error in its inventory valuation. Inventory was over
stated by N70,000 at 31 December 20 X 9 and by N60,000 at 31 December
20 X 8. The rate of tax on profits was 30% in both 20 X 8 and 20 X 9.
The error in 20 X 9 is corrected against the current year profit.
The error in 20X8 is corrected against the prior year profit. (Note that the 20X8
closing inventory is the opening inventory in 20 X 9 so the 20 X 8 adjustment will
impact both periods statements comprehensive income.
Profit adjustments: 20X9 20X8
N000 N000
Profit (20X9 draft and 20X8 actual) 385 150
Deduct error in closing inventory (70) (60)
Add error in opening inventory 60
(10) (60)
Tax at 30% 3 18
(7) (42)
Adjusted profit 378 108

The statement of changes in equity as published in 20 X 9 becomes:
Share Share Retained
capital premium earnings Total
N000 N000 N000 N000
Balance at 31/12/X7 500 50 90 640
Profit for the year (restated) - - 108 108
Balance at 31/12/X8 500 50 198 748
20X9
Dividends (100) (100)
Balance at 31/12/X9 500 50 476 1,026
Period specific effect

It might be impracticable to determine the effect of correcting an error in comparative
information for one or more prior periods presented. For example, it might be
impracticable to determine the impact on profit for the prior year.
In this case a company must restate the carrying amounts of assets and liabilities (and
therefore equity) as at the beginning of the earliest period for which retrospective
restatement is practicable. This may be the current period.
Cumulative effect
It might be impracticable to determine the cumulative effect, at the beginning of the
current period, of correcting an error in all prior periods,
In this case a company must correct the error prospectively from the earliest date
practicable.

3.3 Disclosure of prior period errors
The following information must be disclosed:
▪ the nature of the prior period error;
▪ for each period presented in the financial statements, and to the extent
practicable, the amount of the correction for each financial statement item
and the change to basic and fully diluted earnings per share;
▪ the amount of the correction at the beginning of the earliest prior period in
the statements (typically, at the start of the previous year);
▪ if retrospective re-statement is not practicable for a prior period, an
explanation of how and when the error has been corrected.
IAS 8 therefore requires that a note to the financial statements should disclose
details of the prior year error, and the effect that the correction has had on ‘line
items’ in the prior year.

Example: Disclosure of prior period errors
Returning to the above example the following note would be needed to the financial
statements for the year to 31 December 20 X 9 to explain the adjustments made to
figures previously published for the year to 31 December 20 X 8.
Note about statement of profit or loss. N 000

(Increase) in cost of goods sold (60)
Decrease in tax 18
(Decrease) in profit (42)
Note about statement of financial position N 000
(Decrease) in closing inventory (60)
Decrease in tax payable 18
(Decrease) in equity (42)
4 CHAPTER REVIEW
Define accounting policy
Explain the guidance on the selection of accounting policies
Account for changes in accounting policy
Distinguish between accounting policy and accounting estimate
Account for changes in accounting estimates
Correct errors

CHAPTER
Contents
Introduction to IFRS15
The five step model
Factors affecting the transaction price
Other aspects of IFRS15
Specific examples
Chapter review

Financial reporting
INTRODUCTION
Aim
Detailed syllabus
B Accounting standards and policies relating to specific transactions in financial
statements
5 Inventories and revenue from contracts (IAS 2, IAS 41, IFRS 15)
Calculate where necessary, discuss and account for inventories and revenue
from contracts in accordance with the provisions of relevant accounting
standards (IAS 2, IAS 41 and IFRS 15).
IFRS 15 is an examinable document
Exam context
This chapter explains rules on measuring fair value.
Explain the core principle and the five-step approach to revenue recognition
Apply the five-step approach to revenue recognition
Explain and apply the rules on variable consideration
Explain how the existence of a significant financing components affects revenue
recognition
Account for contract costs
Explain the required accounting treatment in a series of specific areas

Chapter 5: IFRS 15: Revenue from contracts with customers
1 INTRODUCTION TO IFRS 15
Introduction
Core principle and the five step model
1.1 Introduction
The IASB issued IFRS 15: Revenue from contracts with customers in May 2014.
This standard is the end product of a major joint project between the IASB and
the US Financial Accounting Standards Board and replaces IAS 18 and IAS 11.
IFRS 15 sets out principles to be applied in order to report useful information to
users of financial statements about the nature, amount, timing and uncertainty of
revenue and cash flows arising from a contract with a customer.
Definitions
Revenue is income arising in the course of an entity’s ordinary activities.
A customer is a party that has contracted with an entity to obtain goods or
services that are an output of the entity’s ordinary activities.
1.2 Core principle and the five step model

A contract to supply goods and services places a performance obligation (or a
number of performance obligations) on the seller to deliver goods and services in
accordance with the contract. Goods and services being sold are often described
as “deliverables”.
Core principle
IFRS 15 is based on a core principle that requires an entity to recognise revenue:
‰ in a manner that depicts the transfer of goods or services to customers;
‰ at an amount that reflects the consideration the entity expects to be entitled
to in exchange for those goods or services.

Financial reporting
Five step model

Applying this core principle involves following a five step model as follows:
‰ Step 1: Identify the contract(s) with the customer
‰ Step 2: Identify the separate performance obligations
‰ Step 3: Determine the transaction price
‰ Step 4: Allocate the transaction price to the performance obligations
‰ Step 5: Recognise revenue when or as an entity satisfies performance
obligations.
Example: Summary of guidance
X Ltd is a softwaredeveloper.
X Ltd enters into a contract with a customer to transfer a software licence,
perform an installation service and provide unspecified software updates and
technical support for a two-year period.
IFRS 15 provides guidance in the following areas
Step1 Whether the contract is within the scope of IFRS 15 and what
to do if IFRS15 does not apply.
Step2 If IFRS 15 applies, whether the contract contains a single
performance obligation or separate performance
obligations (say for the licence, installation and updates).
Step3 How to identify the transaction price and whether this should
be adjusted for time value ofmoney.
What to do if the consideration might vary depending
on circumstance.
Step4 How the transaction price should be allocated to the
separate performance obligations.
Step5 Whether the performance obligation is satisfied (and
thus revenue recognised) overtime or at a point in time.
The application of IFRS 15 is straightforward for many contracts. However, IFRS

15 provides guidance for complex contracts where there are several deliverables.
Note that revenue recognition and invoicing are two separate processes.
Revenue recognised and amounts invoiced might be the same in many cases but
are not the same in many others.

2 THE FIVE STEP MODEL
Step 1: Identify the contract(s) with a customer

Step 2: Identify the separate performance obligations in the contract
Step 3: Determine the transaction price
Step 4: Allocate the transaction price to the performance obligations
Step 5: Recognise revenue when or as an entity satisfies performance
obligations
Example of revenue recognition where transaction price covers more than one
deliverable
2.1 Step1: Identify the contract(s) with a customer

The first step in IFRS 15 is to identify the contract. This may be written, oral, or
implied by an entity’s customary business practices.
Definition
A contract is an agreement between two or more parties that creates
enforceable rights and obligations.
A contract does not exist if each party has an enforceable right to terminate a
wholly unperformed contract without compensating the other party.
Combination of contracts
Two or more contracts entered into at or near the same time with the same
customer (or related parties) must be combined and treated as a single contract if
one or more of the following conditions are present:
▪ the contracts are negotiated as a package with a single commercial
objective;
▪ the amount of 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 the contracts) are a single performance obligation
Application criteria
The general IFRS 15 model applies only when or if:
▪ the parties have approved the contract and are committed to perform their
respective obligations:
▪ the entity can identify each party’s rights;
▪ the entity can identify the payment terms for the goods and services to be
transferred;
▪ the contract has commercial substance (i.e. it is expected to change the
risk, timing or amount of an entity’s future cash flows); and
▪ it is probable the entity will collect the consideration.

Financial reporting
Example: Application criteria

X Ltd is a real estate developer.
X Ltd enters into a contract with Mr. A for the sale of a building for N m.
Mr. A intends to open a restaurant in the building.
The building is located in an area where new restaurants face high levels of
competition and Mr. A has little experience in the restaurant industry
Mr. A pays a non-refundable deposit of N50,000 and enters in to along-term
financing agreement for the remaining 95% which he will payout of the proceeds
of the restaurant.
X Ltd can repossess the building if Mr. A defaults but cannot seek further
compensation.
Analysis
Have the parties approved the contract and are
Committed to perform their respective obligations Yes
Can X Ltd identify each party’s rights? Yes
Can X Ltd identify the payment terms for the goods
and services to be transferred? Yes
Does the contract have commercial substance? Yes
Is it probable the entity will collect the consideration? No (see below)
It is not probable that X Ltd will collect the consideration because:

(a) Mr A intends to repay the loan from income derived from a
business which faces significant risks (high competition and Mr A’s
limited experience);
(b) Mr. A lacks other income or assets that could be used to repay
the loan; and
(c) Mr. A’s liability under the loan is limited because the loan is
non- recourse.
Conclusion: The contract does not meet the IFRS 15 applicability criteria.
Any consideration received in respect of a contract that does not meet the
criteria is recognised as aliability. This means that in the above example, XLtd
would recognise the N 50,000 received as a liability. This amount would continue
to be recognised as a liability until the application criteria are satisfied or until
either of the following occurs, at which time the amount should be recognised
as revenue.
▪ the entity’s performance is complete and substantially all of the
consideration in the arrangement has been collected and is non-refundable;
▪ the contract has been terminated and the consideration received is non-
refundable.

2.2 Step2: Identify the separate performance obligations in the contract
Definition
A performance obligation is a promise in a contract with a customer to
transfer to the customer 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.
Performance obligations are normally specified in the contract but could also
include promises implied by an entity’s customary business practices, published
policies or specific statements that create a valid customer expectation that
goods or services will be transferred under the contract.
Distinct goods and services

At the inception of a contract the entity must assess the goods or services
promised in a contract and identify as a performance obligation each promise to
transfer to the customer either:
▪ a good or service (or a bundle of goods or services) that is distinct; or
▪ a series of distinct goods or services that are substantially the same and
that have the same pattern of transfer to the customer (described by
reference to promises satisfied over time, and progress to completion
assessment).
A good or service is distinct if both of the following criteria are met:
▪ the customer can benefit from the good or service either on its own or
together with other resources that are readily available to the customer; and
▪ the entity’s promise to transfer the good or service is separately
identifiable from other promises in the contract.
If a promised good or service is not distinct, it must be combined with other
promised goods or services until a bundle of goods or a service that is distinct can
be identified. This could mean that all of the goods or services promised in a
contract might be accounted for as a single performance obligation.
This sounds quite complicated but simply means that at the inception of a contract
an entity must determine whether the contract is for the sale of a single deliverable
or several deliverables. This is important as revenue is recognised as these
separate goods and services are delivered to the customer.

Financial reporting
Example: Distinct goods and services

X Ltd is a contractor which enters into a contract to build a hospital for a
customer.
X Ltd is responsible for the overall management of the project and identifies
various goods and services to be provided, including engineering, site clearance,
foundation, construction of the structure, installation of equipment and finishing.
Are the promised goods and services capable of being distinct?
Analysis
Can the customer benefit from Yes
the goods and services either
X Ltd or its competitors regularly
on their own or to gether with
sells many of these goods and
other readily available
services separately to other
resources?
customers.
Also, the customer could generate
economic benefit from the individual
goods and services by using,
consuming, selling or holding those
goods or services.
Is X Ltd’s promise to transfer No
individual goods and services in
X Ltd provides a significant service
the contract separately
of integrating the goods and
identifiable from other promises
services (the inputs) into the hospital
in the contract?
(the combined output) for which the
customer has contracted.
Conclusion: X Ltd should account for all of the goods and services
in the contract as a single performance obligation.

Example: Distinct goods and services
X Ltd is a softwaren developer.

X Ltd enters into a contract with a customer to transfer a software licence,
perform an installation service and provide unspecified software updates and
technical support for a two-year period.
X Ltd sells the licence, installation service and technical support separately.
The installation service is routinely performed by other entities and does not
significantly modify the software.
Are the promised goods and services capable of being distinct?
Analysis
Can the customer benefit from Yes
thegoodsandserviceseitheron
The customer can benefit from
their own or together with other
each of the good sand services
readily available resources?
either on their own or together with
the other goods and services that
are readily available.
Is X Ltd’s promise to transfer Yes
individualgoodsandservicesin
The installation service does not
the contract separately
significantly modify or customise the
identifiable from otherpromises
software so the software and the
in the contract?
installation service are separate
outputs instead of inputs used to
produce a combined output
Conclusion:X Ltd should account for four separate performance

obligations (the software licence, the installation service,
software updates and technical support).

Financial reporting
2.3 Step3: Determine the transaction price
Definition
The transaction price is the amount of consideration an entity expects to be
entitled to in exchange for the goods or services promised under a contract,
excluding any amounts collected on behalf of third parties (for example, sales
taxes).
An entity must consider the terms of the contract and its customary practices in
determining the transaction price.
The transaction price assumes transfers to the customer as promised in
accordance with the existing contract and that the contract will not be cancelled,
renewed or modified.
The transaction price is adjusted if the entity (e.g., based on its customary
business practices) has created a valid expectation that it will enforce its rights
for only a portion of the contract price.
The nature, timing and amount of consideration promised by a customer affect
the estimate of the transaction price. An entity must consider the effects of other
factors when determining the transaction price including:
▪ variable consideration (including the constraining estimates of variable
consideration); and
▪ time value of money;
These are covered in more detail later in this chapter.
2.4 Step4: Allocate the transaction price to the performance obligations

The objective is to allocate the transaction price to each performance obligation
(or distinct good or service) in an amount that depicts the amount of
consideration to which the entity expects to be entitled in exchange for
transferring the promised goods or services to the customer.
The transaction price is allocated to each performance obligation in proportion to
those stand-alone selling prices determined at the inception of the contract.
Definition
A stand-alone selling price is the price at which an entity would sell a
promised good or service separately to a customer.
Allocation of a discount
When the sum of the stand-alone selling prices of goods or services promised in
a contract exceeds the promised consideration the customer is receiving a
discount.
The discount should be allocated entirely to one or more (but not all)
performance obligations in the contract if all of the following criteria are met:
▪ each distinct good or service (or each bundle of distinct goods or services)
in the contract is sold regularly on a stand-alone basis;

▪ a bundle (or bundles) of some of those distinct goods or services are sold
regularly at a discount to the stand-alone selling prices of the goods or
services in each bundle; and
▪ such discounts are substantially the same as the discount in the contract.
Example: Allocation of discount

X Ltd sells three products at the following stand-alone selling prices:
Stand-alone
selling price
ProductA 40
ProductB 55
ProductC 45
X Ltd sells one ach of the products to Y Plc for N100 in total. Products B and C are
sold regularly together or N60.
The products are to be delivered at three different points in time. The delivery of
each product is a separate performance obligation.
X Ltd regularly sells Products Band C together for N60 and Product A for N40.
Therefore, the entire discount should be allocated to the promises to transfer
Products B and C.
The discount of N40 is allocated as follows:
Stand-alone Allocated discount. Allocated
selling price transaction price
ProductA 40 40
ProductB 55 (55 u40/100) =22 33
ProductC 45 (45 u40/100) =18 27
140 100
Note that if the contract required delivery of B and C at the same time, X Ltd
could account for that delivery as a single performance obligation.
The discount of N40 would then be allocated as follows:
Stand-alone Allocated Allocated
selling price discount. transaction price
Product A 40 40
Product B and C 100 40 60
140 100
In other cases, the discount is allocated proportionately to all performance

obligations in the contract.

Financial reporting
Example: Allocation of discount

X Ltd sells three products at the following stand-
alonesellingprices:
Stand-alone
N
ProductA
Products are not usually sold at a discount but X Ltd agrees to sell one each of
for N in
The products are to be delivered at three different points in time. The delivery
of each product is a separate performance obligation.
There is no observable evidence about which performance obligation has
attracted the discount.
N
Stand-alone Allocated discount. Allocated
N transaction price
ProductA
2.5 Step 5: Recognise revenue when or as an entity obligations

Revenue is recognised when (or as) a company satisfies a performance obligation
by transferring a promised good or service to a customer. The amount of revenue
recognised is the amount of the transaction price allocated to the performance
obligation.
Goods and services are assets, even if only momentarily, when they are received
and used (as in the case of many services). An asset is transferred when (or as)
the customer obtains control of that asset. Control of an asset refers to the ability
to direct the use of, and obtain substantially all of the remaining benefits from, the
asset.
A performance obligation might be satisfied (i.e., goods and services might be
transferred):
– over time (in which case revenue would be recognised over time); or
– at a point in time (in which case revenue is recognised at that point in time).
Performance obligations satisfied over time

A company must identify at the inception of the contract whether a performance
obligation will be satisfied over time or at a point in time.

A company transfers control of a good or service over time (therefore, satisfying a

performance obligation and recognising revenue over time), if one of the following
criteria is met:
▪ the customer simultaneously receives and consumes the benefits provided
by the entity’s performance as the entity performs;
▪ the company’s performance creates or enhances an asset (for example,
work in progress) that the customer controls as the asset is created or
enhanced; or
▪ the company’s performance does not create an asset with an alternative
use (to the seller) and the entity has an enforceable right to payment for
performance completed to date.
If a performance obligation is satisfied over time an entity needs a mechanism to
identify the extent to which the performance obligation has been met.
Example: Performance obligation satisfied over time

X Ltd enters into a contract to provide monthly payroll processing services to a
customer for one year
Is the performance obligation satisfied over time?
Analysis
a. Does the customers Yes (criterion met)
imultaneously receive and
consume the benefits provided?
b. Does X Ltd’s performance Yes (criterionmet)
createor enhance an asset that
The asset being the ability
the customer controls as it is
to process payroll
created or enhanced
c. Does X Ltd’s performance No (this part of the criterion met)
create an asset with an
alternative use
and
Yes probably (this part of
does X Ltd have an enforceable the criterionmet)
right to payment for performance
completed to date
Conclusion: The performance obligation is satisfied overtime. (All

three criteria are actually met)
There would be no need to consider criteria or concecriteri on a

was met, only one criterion need be achieved.

Financial reporting
Performance obligations satisfied at a point in time?

If a performance obligation is not satisfied over time then it is satisfied at a point
in time.
Measuring progress towards complete satisfaction of a performance

obligation
For a performance obligation satisfied over time, revenue is recognised by
measuring the progress towards complete satisfaction of that performance
obligation.
‰ A single method of measuring progress should be used for each
performance obligation and that method should be applied consistently to
similar performance obligations and in similar circumstances.
‰ Progress must be remeasured at the end of each reportingperiod.
Possible methods of measuring progress include both output methods and input
methods.
Output methods
Output methods recognise revenue on the basis of 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.
Output methods include methods such as:
▪ surveys of performance completed to date;
▪ appraisals of results achieved;
▪ mile stones reached;
▪ time elapsed and units produced; or
▪ units delivered.
The output should faithfully depict the entity’s performance towards complete
satisfaction of the performance obligation.
The disadvantages of output methods are that the outputs used may not be
directly observable and the information required to apply them may not be
available without undue cost. Therefore, an input method may be necessary.

Example: Performance obligations satisfied over time

X Ltd owns and manages health clubs.
X Ltd enters into a contract with a customer for one year of access to any of its
health clubs.
The customer has unlimited use of the health clubs and promises to pay N100
per month.
(Note that the promise is to provide access to the health clubs. Whether the
customer uses the club or not is irrelevant to how X Ltd accounts for revenue).
Is the performance obligation satisfied over time?
Analysis
a. Does the customer Yes (criterion met)
simultaneously receive and
The customer receives and
consume the benefits
consumes the benefits of X Ltd’s
provided?
performance as X Ltd makes the
health club available for the
customer’s use.
How should progress towards complete satisfaction of the performance

obligation be measured?
The customer benefits from the entity’s service of making the health
clubs available evenly throughout the year.
The best measure of progress towards complete satisfaction of
the performance obligation overtime is a time-based measure.
X Ltd should recognise revenue of N100 per month.
Input methods
Input methods recognise revenue on the basis of the entity’s efforts or inputs to
the satisfaction of a performance obligation by comparing input to date to the
expected total input. For example:
▪ labour hours expended relative to total expected labour hours to satisfy the
performance obligation
▪ costs incurred relative to expected total costs to satisfy the performance
obligation.
It may be appropriate to recognise revenue on a straight-line basis where they
are expended evenly throughout the performance period.

Financial reporting
Example: Measure of progress based on inputs

X Ltd is engaged on a contract to construct a building at a transaction price of
N3,200,000.
The contract represents a single performance obligation.
X Ltd recognizes progress in satisfying the performance obligation by comparing
costs incurred to date to total expected costs (costs incurred to date plus an
estimate of expected future costs).
X Ltd has not yet recognised any revenue on this
contract. The following cost information is available:
N
Costs incurred to date 1,500,000
Estimated costs to complete 1,000,000
Total expected costs 2,500,000
Revenue should be recognised as follows:

Tota ltransaction price N 3,200,000
Measure of progress
1,500,000/2,500,000u100 60%
Revenue recognised N 1,920,000
N in
accounting treatment of contract costs is covered later.
Sometimes, there may not be a direct relationship between an entity’s inputs and
the transfer of control of goods or services to a customer.
Any input that does not represent performance in transferring control of goods or
services must be excluded from the input method.
Adjustment to the measure of progress may be required in the following
circumstances:
– When a cost incurred does not contribute to an entity’s progress in
satisfying the performance obligation. For example, an entity would not
recognise revenue on the basis of costs incurred that are attributable to
significant inefficiencies in the entity’s performance that were not reflected
in the price of the contract.
– When a cost incurred is not proportionate to the entity’s progress in
satisfying the performance obligation. In those circumstances, the best
depiction of the entity’s performance may be to adjust the input method to
recognise revenue only to the extent of that cost incurred.

Example: Adjustment to the measure of progress due to inefficiencies

N3,200,000.
X Ltd recognises progress in satisfying the performance obligation by comparing
X Ltd has not yet recognised any revenue on this contract.
X Ltd had to pay to re-lay a concrete foundation which did not set properly due
to a sudden frost after it was laid
There is no provision in the contract for the customer to meet the cost of any
necessary rectifications.
The following cost information is available:
Without With
rectification rectification
Costs incurred to date N N
Rectification costs 100,000
Other costs 1,400,000 1,400,000
1,400,000 1,500,000
Estimated costs to complete 1,000,000 1,000,000
Total expected costs 2,400,000 2,500,000
Revenue should be recognised as follows (excluding the effect of the

inefficiency): Total transaction price N3,200,000
Measure of progress
1,400,000/2,400,000 u 100 58.33%
Revenuerecognised N1,866,667
Further explanation
Suppose the rectification had occurred on the last day of the
accounting period. Before the rectification X Ltd had spent N1,400,000
out of an expected total of 2,400,000 leading it to consider that the
contract was 58.33% complete.
However, the need to replace the foundation meant that the contract
was not as complete as thought. There ctification restored progress
back to 58.33% but did not add to it.

Financial reporting
The measurement of progress is cumulative. In other words, it measures the

revenue that should be recognised by the period end.
Each of the above examples has assumed that revenue from each of the contracts
had not been recognised until this period. If revenue had been recognised in an
earlier period only the incremental revenue should be measured (total revenue to
be recognised by the end of the period less total revenue recognised by the end
of the previous period).
Example: Measure of progress based on inputs

N3,200,000.
X Ltd recognises progress in satisfying the performance obligation by comparing
The following cost information is available:
Year1 Year2
N N
Costs incurred to date 1,500,000 2,000,000
Total expected costs 2,500,000 2,500,000
Revenue should be recognised as follows:

Total transaction price N3,200,000
N3,200,000
Measure ofprogress
1,500,000/2,500,000u100 60%
2,000,000/2,500,000u100 80%
Revenue to be recognised by the end of
the period N1,920,000
N2,560,000
Revenue recognised in previous period nil
N1,920,000
Revenue recognised this period N1,920,000 N 640,000

2.6 Example of revenue recognition where transaction price covers more

than one deliverable
The following example illustrates steps 3 to 5 of the model (ignoring the time
value of money).
Example: Revenue recognition

X Plc sells mobile phones and network contracts either together or separately.
Revenue from selling a bundle (handset together with a network contract) would
be recognised using the following steps.
Step 3: Determine the transaction price
Sold Sold as a
separately bundle
Handset 53,100 –
Monthly network fee 2,500 5,000
Number of months 24 24
N
60,000 120,000
Total 113,100 120,000
Step 4: Allocate the transaction price

The transaction price of the bundle (N120,000) is allocated inproportion to
the stand-alone selling prices of distinct goods and services promised in
the contract.
Thus, the revenue allocation is as follows:
N
Handset (N120,000u N53,100/N113,100) 56,340
Network contract (N120,000 u N60,000/ N113,100) 63,660
120,000

Financial reporting
Example (continued): Revenue recognition price (ignoring time value)

Step 5: Recognise revenue
The revenue for the handset is recognised when it is delivered at the start of
the contract. There is no cash received at this point in time so a receivable
is recognised to complete the revenue double entry.
Handset Dr Cr
Receivable 56,340
Revenue 56,340
The revenue for the network contract is recognised over the life of the
contract.
The difference between the cash received each month and the amount
recognised as revenue in the statement of profit or loss pays for the
handset and reduces the receivable to zero by the end of the 24-month
contract period.
Network contract Dr Cr
Cash 5,000
Revenue (N63,660 ÷ 24months) 2,653
Receivable (paying for the handset) 2,347
Or over the life of the contract (as a

proof)
Dr Cr
Cash 120,000
Revenue (N2,653 u 24months) 63,660
Receivable (N2,347u 24months) 56,340
The above example does not take time value into account.
The stand alone selling prices used above are inconsistent with each other. The
N53,100 for the handset is payable up front but the N60,000 for the contract is
payable by a series of monthly payments over a 24-month period. Inpractice,
this would be taken into account.

3 FACTORS AFFECTING THE TRANSACTION PRICE
Variable consideration
Financing component
3.1 Variable consideration

The amount of consideration for the sale of goods and services might be variable
due to the existence of discounts, price concessions, incentives, performance
bonuses, penalties and similar items.
Consideration can also vary if its amount is contingent on the occurrence or non-
occurrence of a future event. For example, where a product is sold with a right of
return or a fixed amount is promised as a performance bonus on achievement of
a specified milestone.
The variability relating to the consideration promised by a customer may be
explicitly stated in the contract. However, in addition to the terms of the contract,
the consideration is variable if either of the following circumstances exists:
▪ the customer has a valid expectation arising from an entity’s customary
business practices, published policies or specific statements that the entity
will accept an amount of consideration that is less than the price stated in
thecontract.
▪ other facts and circumstances indicate that the entity’s intention, when
entering into the contract with the customer, is to offer a price concession to
the customer.
If consideration includes a variable amount an entity must estimate the amount of
consideration to which it will be entitled in exchange for transferring the promised
goods or services to a customer.
The amount of variable consideration should be estimated by using either of the
following methods:
▪ Expected value: the sum of probability weighted amounts in a range of
possible consideration amounts. This may be an appropriate estimate if an
entity has a large number of contracts with similar characteristics.
▪ The most likely amount: the single most likely amount in a range of possible
consideration amounts. This may be an appropriate estimate of the amount
of variable consideration if the contract has only two possible outcomes (for
example, an entity either achieves a performance bonus or does not).
The method used should be the method expected to better predict the amount of
consideration and should be applied consistently throughout the contract.

Financial reporting
Refund liabilities
An entity might expect to return some (or all) of the consideration received from a
customer. Such consideration must be recognised as a refund liability.
A refund liability is measured at the amount of consideration received (or
receivable) for which the entity does not expect to be entitled. It must be updated
at the end of each reporting period for changes in circumstances.
Example: Variable consideration

N
Cash is received when control of a product transfers.
X Ltd allows customers to return any unused product within 30days and receive
a full refund.
N
X Ltd has considerable experience of selling this type of product. Based on this
experience it estimates that 97 products will not be returned. Therefore, X Ltd
will not recognise the revenue on three products.
X Ltd will recognise the following on the inception of the contracts:
Dr Cr
Cash (100u N100) 10,000
Revenue (97u N100) 9,700
Refund liability (3u N100) 300
N N for right
This is of the nature of an inventory adjustment.(Remember that the cost of

100 items N not in
Constraining estimates of variable consideration

The ability to estimate variable consideration does not necessarily mean that it
would be included in the transaction price as there might be constraints on the
estimate.
Variable consideration is included in the transaction price only to the extent that it
is highly probable that a significant reversal of the amount of cumulative revenue
recognised will not occur when any uncertainty associated with the variable
consideration is subsequently resolved.
This sounds complicated but it means that the variable consideration should only
be included if it is highly probable that the entity will earn the amount after all
uncertainties are resolved. (The variable consideration is included in the
transaction price when the company expects to receive it).

Allocation of variable consideration

Variable consideration may be attributable to the entire contract or to a specific
part of the contract.
A variable amount (and subsequent changes to that amount) should be allocated
entirely to a performance obligation if both of the following criteria are met:
– the terms of a variable payment relate specifically to the entity’s efforts to
satisfy the performance obligation; and
– the allocation is consistent with the IFRS 15 allocationobjective.
Royalties
Regardless of the above, revenue for a sales-based or usage-based royalties
promised in exchange for a licence of intellectual property is recognised only
when (or as) the later of the following events occurs:
– the subsequent sale or usage occurs; and
– the performance obligation to which some or all of the sales-based or
usage-based royalty has been allocated has been satisfied (or partially
satisfied).
3.2 Financing component

The agreed timing of payments in a contract might have the effect of the contract
containing a significant financing component. This could occur due to explicit or
implied terms in the contract.
In such cases, the transaction price must be adjusted for the effects of the time
value of money with the objective of recognising revenue at an amount that reflects
the cash price that a customer would have paid for the goods or services.
No adjustment is necessary if the period between the transfer of, and payment
for, the promised good or service is expected to be one year or less.
Discount rate
The discount rate used should be one that would be reflected in a separate
financing transaction between the entity and its customer at contract inception.
The rate would reflect both credit characteristics and collateral or security provided
by the parties. It might be possible to identify the rate as that rate which discounts
the nominal amount of the promised consideration to the price that the customer
would pay in cash for the goods or services when (or as) they transfer to the
customer.
Presentation
The effects of financing (interest revenue or interest expense) must be presented
separately from revenue from contracts with customers in the statement of
comprehensive income.

Financial reporting
Example: Financing component

An enterprise sells a machine on 1 January 20X5. The terms of sale are that the
An appropriate discount rate is 6%.
Initial measurement of the = N
Debit Credit
N4,449,9
Revenue 82 4,449,982
31 December 20 X 5
Recognition of interest revenue
=
Debit Credit
Receivables 266,999
Revenue–interest
Balanceonthereceivable N
Balance broughtforward 4,449,982
Interestrevenuerecognisedintheperiod 266,999
Carried forward 4,716,981
31December 20X6
Recognition ofinterestrevenue N =
Debit Credit
Receivables 283,019
Revenue–interest
Balanceonthereceivable N
Balance brought forward 4,716,981
Interest revenue recognised in the period 283,019
Consideration received (5,000,000)
Carried forward

4 OTHER ASPECTS OF IFRS 15
Section overview
„ Contract costs
„ Costs to fulfil a contract
„ Amortisation and impairment
„ Presentation
4.1 Contract costs

Costs might be incurred in obtaining a contract and in fulfilling that contract.
The incremental costs of obtaining a contract with a customer are recognised as
an asset if the entity expects to recover those costs.
The incremental costs of obtaining a contract are those costs that would not have
been incurred if the contract had not beenobtained.
Costs to obtain a contract that would have been incurred regardless of whether
the contract was obtained are expensed as incurred (unless they can be
recovered from the customer regardless of whether the contract is obtained).
Example: Incremental costs of obtaining a contract

X Ltd wins a competitive bid to provide consulting services to a new
customer. X Ltd incurred the following costs to obtain the contract:
N
Commissions to sales employees for winning the contract
External legal fees for due diligence
Travel costs to deliver proposal
Total costsincurred
The commission to sales employees is incremental to obtaining the contract and

should be capitalised as a contract asset.
The external legal fees and the travelling cost are not incremental to obtaining
the contract because they have been incurred regardless of whether X Ltd
obtained the contract or not.
An entity may recognise the incremental costs of obtaining a contract as an

expense when incurred if the amortisation period of the asset that the entity
otherwise would have recognised is one year or less.

Financial reporting
4.2 Costs to fulfil acontract

Costs incurred in fulfilling a contract might be within the scope of another standard
(for example, IAS 2: Inventories, IAS 16: Property, Plant and Equipment or IAS 38:
Intangible Assets). If this is not the case, the costs are recognised as an asset only
if they meet all of the following criteria:
▪ the costs relate directly to a contract or to an anticipated contract that the
entity can specifically identify;
▪ the costs generate or enhance resources of the entity that will be used in
satisfying (or in continuing to satisfy) performance obligations in the future;
and
▪ the costs are expected to berecovered.
Costs that relate directly to a contract might include:
▪ direct labour and direct materials;
▪ allocations of costs that relate directly to the contract or to contract
activities;
▪ costs that are explicitly chargeable to the customer under the contract; and
▪ other costs that are incurred only because an entity entered into the
contract (e.g., payments to subcontractors).
The following costs must be recognised as expenses when incurred:
▪ general and administrative costs (unless those costs are explicitly
chargeable to the customer under thecontract);
▪ costs of wasted materials, labour or other resources to fulfil the contract
that were not reflected in the price of thecontract;
▪ costs that relate to satisfied performance obligations (or partially satisfied
performance obligations) in the contract (i.e., costs that relate to past
performance).
4.3 Amortisation and impairment

An asset for contract costs recognised in accordance with this standard must be
amortised on a systematic basis consistent with the transfer to the customer of
the goods or services to which the asset relates.
The amortisation must be updated to reflect a significant change in the entity’s
expected timing of transfer to the customer of the goods or services to which the
asset relates.
An impairment loss must be recognised in profit or loss to the extent that the
carrying amount of an asset 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 costs that relate directly to providing those goods or services and that
have not been recognised asexpenses.
When the impairment conditions no longer exist or have improved a reversal of
the impairment loss is recognised. This will reinstate the asset but the increased
carrying amount of the asset must not exceed the amount that would have been
determined (net of amortisation) if no impairment loss had been recognised
previously.

Example: Amortisation of contract costs

X Ltd wins a 5-year contract to provide a service to a customer.
The contract contains a single performance obligation satisfied overtime. X Ltd
recognizes revenue on a time basis
Costs incurred by the end of year 1 and forecast future costs areas follows:
N
Costs to date 10,000
Estimate of future costs 18,000
Total expected costs 28,000
Cost must be recognised in the P&L on the same basis as that used to recognise
revenue.
X Ltd recognizes revenue on a time basis, therefore 1/5 of the total expected cost
=N
Example: Amortisation of contract costs

X Ltd wins a contract to build an asset for a customer. It is anticipated that the
asset will take 2 years to complete
The contract contains a single performance obligation. Progress to completion
is measured on an out put basis.
At the end of year 1 the assets is 60% complete.
Costs incurred by the end of year 1 and forecast future costs are as follows:
N
Costs to date 10,000
Estimate of future costs 18,000
Total expected costs 28,000
Costs must be recognised in the P&L on the same basis as that used to
recognise revenue.
N
end of year 1.

Financial reporting
4.4 Presentation
This section explains how contracts are presented in the statement of financial
position. In order to do this, it explains the double entries that might result from
the recognition of revenue. The double entries depend on circumstance.
An unconditional right to consideration is presented as a receivable.
The accounting treatment to record the transfer of goods for cash or for an
unconditional promise to be paid consideration is straight forward.
Illustration: Possible double entries on recognition of revenue

Debit Credit
Cash X
Receivable X
Revenue X
Example: Double entry – Unconditional right to consideration

1 January 20 X 8
X Ltd enters into a contract to transfer Products A and B to Y Plc in exchange for
N1,000.
Product A is to be delivered on 28 February.
Product B is to be deliveredon31March.
The promises to transfer Products A and B are identified as separate
performance obligations. N400 is allocated to Product A and N600 to Product B.
X Ltd recognises revenue and recognises its unconditional right to the
consideration when control of each product transfers to Y Plc.
The following entries would be required to reflect the progress of the contract).
Contract progress
28 February: X Ltd transfers Product A to Y plc.
At 28 February Dr(N) Cr(N)

Receivables 400
Revenue 400
31 March: X Ltd transfers Product B to Y plc 31 March

Receivables 600
Revenue 600
In other cases, a contract is presented as a contract asset or a contract liability

depending on the relationship between the entity’s performance and the
customer’s payment.

Contract assets
A supplier might transfer goods or services to a customer before the customer
pays consideration or before payment is due. In this case the contract is
presented as a contract asset (excluding any amounts presented as a
receivable).
A contract asset is a supplier’s right to consideration in exchange for goods or
services that it has transferred to a customer. A contract asset is reclassified as a
receivable when the supplier’s right to consideration becomes unconditional.
Example: Double entry–Recognition of a contract asset 1 January 20 X 8

X Ltd enters into a contract to transfer Products A and B to Y Plc in exchange for
N1,000.
Product A is to be delivered on 28 February. Product B
is to be delivered on 31 March.
performance obligations. N400 is allocated to Product A and N600 to Product B.
Revenue is recognised when control of each product transfers to Y Plc.
Payment for the delivery of Product A is conditional on the delivery of Product B.
(i.e., the consideration of N1,000 is due only after X Ltd has transferred both
Products A and B to Y Plc). This means that X Ltd does not have a right to
consideration that is unconditional (a receivable) until both Products A and B are
transferred to YPlc.
The following entries would be required to reflect the progress of the contract
Contract progress
The following accounting entries would be necessary:
28 February: X Ltd transfers Product A to Y plc
X Ltd does not have an unconditional right to receive the N400 so the amount is
recognised as a contract asset.

Contract asset 400
Revenue 400
31 March: X Ltd transfers Product B to Y plc

X Ltd now has an unconditional right to receive the full N1,000. The N400
previously recognised as a contract asset is reclassified as a receivable and
the N600 for the transfer of product Bisal so recognised as receivable.
31 March Dr(N) Cr(N)

Receivable 1,000
Contract asset 400
Revenue 600

Financial reporting
Contract liabilities
A contract might require payment in advance or allow the supplier a right to an
amount of consideration that is unconditional (i.e., a receivable), before it transfers
a good or service to the customer.
In these cases, the supplier presents the contract as a contract liability when the
payment is made, or the payment is due (whichever is earlier).
The contract liability is a supplier’s obligation to transfer goods or services to a
customer for which it has received consideration (an amount of consideration is due)
from the customer.
Example: Double entry – Recognition of a contract liability

1 January 20X8
X Ltd enters into a contract to transfer Products A and B to Y Plc in exchange
For N1,000.
X Ltd can invoice this full amount on 31 January.
Product A is to be delivered on 28 February.
Product B is to be delivered on 31 March.
performance obligations N400 is allocated to Product A and N600 to Product B.
Revenue is recognised when control of each product transfers to Y Plc.
The following entries would be required to reflect the progress of the contract
Contract progress
The following accounting entries would be necessary:
At 31 January Dr(N) Cr(N)

Receivable 1,000
Contract liability 1,000
28 February: X Ltd transfers Product A to Y plc

Contract liability 400
Revenue 400
31 March: X Ltd transfers Product B to Y plc
31 March Dr(N) Cr(N)

Contract liability 600
Revenue 600

5 SPECIFIC EXAMPLES
Principal versus agent considerations

Sale with a right toreturn
Repurchase agreements
Bill and holdsales
Consignment sales
5.1 Principal versus agent considerations

A person or company might act for another company. In this case the first
company is said to be an agent of the second company and the second company
is described as the principal.
Principal
An entity is a principal if it controls a promised good or service before it is
transferred to a customer. However, an entity is not necessarily acting as a
principal if it obtains legal title of a product just before legal title is transferred to a
customer.
A principal is responsible for satisfying a performance obligation. It may do this by
itself or it may engage another party (for example, a subcontractor) to help do this.
A principal recognises the gross amount of revenue to which it is entitled for
goods and services transferred.
Agent
An agent’s performance obligation is to arrange for the provision of goods or
services by another party (the principal).
The agent is providing a selling service to the principal. The agent should not
recognise the whole sale price of the goods but only the fee for selling them.
When an agent satisfies a performance obligation, it recognises revenue in the
amount of any fee or commission to which it expects to be entitled in exchange
for arranging for the principal to provide its goods or services.
An agent might sell goods for a principal and collect the cash from the sale. The
agent then hands the cash to the principal after deducting an agency fee.

Financial reporting
Example: Agency
X Ltd distributes goods for Y plc under an agreement with the following terms.
1. X Ltd is given legal title to the goods byY plc and sells them to the retailers.
2. Y plc sets these lling price and X Ltd is given a fixed margin on all sales.
3. Y plc retains all product liability and is responsible for any manufacturing
defects.
4. X Ltd has the right to return inventory toY plc without penalty.
5. X Ltd is not responsible for credit risk on sales made.
During they earended 31 December 20 X 3 Y plc transferred legal title of good sto
X Ltd which cost Y plc N1,000,000. These are to be sold at a mark-up of 20%. X Ltd
is entitled to 5% of these lling price of all goods sold.
As at 31 December X Ltd had sold 90% of the goods and held the balance of the
inventory in its warehouse. All amounts had been collected by X Ltd but the
company has not yet remitted any cash to Y plc.
Analysis:
In substance X Ltd is acting as an agent for Y plc. Y plc retains all significant risks
and rewards of ownership of the goods transferred to X Ltd.
X Ltd would recognise: Dr Cr
Cash (90% u (N1,000,000 u 120%) 1,080,000
Revenue (5% u 90% u (N1,000,000 u 120%) 54,000
Liability 1,026,000
Y plc would recognise: Dr Cr

Receivable 1,026,000
Revenue 1,026,000
Y plc would also recognise the unsold inventory as part of its

closing inventory.
It is usually straightforward to decide if an entity is an agent or a principal.

The determination is based on the nature of the promise of a party in a contract.
Indicators that an entity is an agent (and therefore does not control the good or
service before it is provided to a customer) include the following:
▪ another party is primarily responsible for fulfilling the contract;
▪ the entity does not have inventory risk before or after the goods have been
ordered by a customer, during shipping or on return;
▪ the entity does not have discretion in establishing prices for the other
party’s goods or services and, therefore, the benefit that the entity can
receive from those goods or services is limited;
▪ the entity’s consideration is in the form of a commission; and
▪ the entity is not exposed to credit risk for the amount receivable from a
customer in exchange for the other party’s goods or services.

5.2 Sale with a right to return

Some contracts result in the transfer of control of a product to a customer but also
grant the customer the right to return the product for various reasons (such as
dissatisfaction with the product) and receive any combination of the following:
▪ a full or partial refund of any consideration paid;
▪ a credit that can be applied against amounts owed, or that will be owed, to
the entity; and
▪ another product in exchange.
All of the following must be recognised when a product is sold with a right of
return:
▪ revenue for the transferred products in the amount of consideration to
which the entity expects to be entitled (i.e., revenue would not be
recognised for the products expected to be returned);
▪ a refund liability; and
▪ an asset (and corresponding adjustment to cost of sales) for its right to
recover products from customers on settling the refund liability.

Financial reporting
5.3 Repurchase agreements

A repurchase agreement is a contract in which an entity sells an asset and also
promises or has the option (either in the same contract or in another contract) to
repurchase the asset.
A customer does not obtain control of the asset when the selling entity has an
obligation or a right to repurchase the asset.
Even though the customer may have physical possession of the asset, the
customer is limited in its ability to direct the use of and obtain substantially all of
the remaining benefits from the asset.
If the repurchase agreement is a financing arrangement, the entity must continue
to recognise the asset and also recognise a financial liability for any consideration
received from the customer.
The difference between the amount of consideration received from the customer
and the amount of consideration to be paid to the customer is recognised as
interest.
Example: Sale and repurchase agreement (forward)

X Ltd is in the forestry business. It cuts wood and seasons it for 3 to 4 years before
selling it to furniture manufacturers.
X Ltd sells 1,000 tonnes of wood to a bank for N 1,000,000
X Ltd has a contract under which it will buy the wood back from the bank in one
The wood will never leave X Ltd’s premises.

Analysis:
X Ltd has a contract under which it will buy the wood back at the sale proceeds plus
a lender’s return.
X Ltd has borrowed cash using its inventory as security.
X Ltd must recognise the “sale proceeds” as a liability (Dr Cash Cr Liability).
The double entry is asfollows: Dr Cr
1 January
Cash 1,000,000
Liability 1,000,000
Year to 31 December
Interest expense (statement of profit or loss) 100,000
Liability 100,000
Being: Recognition of interest on loan
Liability 1,100,000
Cash 1,100,000
Being: Repayment of loan

5.4 Bill and hold sales

A bill-and-hold arrangement is a contract under which goods are sold to a
customer but held at the selling entity’s premises until the customer requests
delivery. For example, a customer may request an entity to enter into such a
contract because of the customer’s lack of available space for the product.
Revenue for a bill-and-hold sale is recognised in the usual way, according to
whether the customer has obtained control of the asset.
The selling entity needs to determine when it satisfies its performance obligation
to transfer a product by evaluating when a customer obtains control of that
product.
For some contracts, this could occur (and revenue be recognised) when the
product is shipped from the selling entity’s site or delivered to the customer’s site
depending on the terms of the contract.
However, a customer might have the ability to direct the use of, and obtain
substantially all of the remaining benefits from, the product even though it has
decided not to exercise its right to take physical possession of that product. In
this case the selling entity does not control the product. In this case, revenue
would be recognised when the goods were originally sold.
For a customer to have obtained control of a product in a bill-and-hold
arrangement, all of the following criteria must be met:
– the reason for the bill-and-hold arrangement must be substantive (for
example, the customer has requested the arrangement);
– the product must be identified separately as belonging to the customer;
– the product currently must be ready for physical transfer to the customer;
and
– the selling entity cannot have the ability to use the product or to direct it to
another customer.
If the selling entity recognises revenue for the sale of a product on a bill-and-hold
basis, it should also consider whether it has remaining performance obligations.
For example, it might consider that it is providing a warehousing service to the
customer. In such cases, the transaction price must be allocated between the
goods sold and that service in the usual way.

Financial reporting
Example: Bill and hold arrangement

X Ltd enters into a contract with Y Plc for the sale of a machine and spare parts.
Y Plc pays for the machine and spare parts on 31 December 20 X 9, but only takes
physical possession of the machine, requesting that the spare parts be stored at X
Ltd’s warehouse because of its close proximity toY Plc’s factory.
Further information
Y Plc has legal title to the spare parts and the parts can be identified as
belonging to Y Plc.
X Ltd stores the spare parts in a separate section of its warehouse and the parts
are ready for immediate shipment at Y Plc’s request.
X Ltd does not have the ability to use the spare parts or direct them to another
customer.
X Ltd expects to hold the spare parts for three years.
Analysis:
The promises to transfer the machine and spare parts are distinct and result in
two performance obligations that each will be satisfied at a point in time.
The promise to provide custodial services is a service provided to Y Plc, distinct
from the machine and spare parts. It is a performance obligation.
X Ltd should account for three performance obligations in the contract (the
promises to provide the machine, the spare parts and the custodial services).
The transaction price is allocated to the three performance obligations and
revenue is recognised when (or as) control transfers to Y Plc.
Revenue recognition
Control of the machine transfers toY Plc on 31 December 20 X 9 when Y Plc
takes physical possession.
X Ltd assesses the indicators in IFRS 15 to determine the point in time at which
control of the spare parts transfers to Y Plc.
X Ltd concludes that all of the necessary criteria are met for X Ltd to recognise
revenue in a bill-and-hold arrangement. X Ltd recognises revenue for the spare
parts on 31 December 20 X 9 when control transfers to Y Plc.
The performance obligation to provide custodial services is satisfied over time
as the services are provided. Revenue is recognised over time as the
warehousing service is provided.
Note: X Ltd would also need to consider whether the payment terms include a
significant financing component and account for it accordingly.

5.5 Consignment sales

An entity might deliver a product to another party (such as a dealer or a
distributor) for sale to end customers under a consignment arrangement.
Indicators that an arrangement is a consignment arrangement include (but are
not limited to) the following:
▪ the product is controlled by the entity until a specified event occurs, such as
the sale of the product to a customer of the dealer or until a specified period
expires;
▪ the entity is able to require the return of the product or transfer the product
to a third party (such as another dealer); and
▪ the dealer does not have an unconditional obligation to pay for the product
(although it might be required to pay a deposit).
These arrangements are common in the car industry where manufacturers
deliver cars to showrooms on consignment.
Control of a product held in a consignment arrangement has not passed.
Revenue is not recognised upon delivery of a product held on consignment but at
a later point in time (depending on terms in the contract).
Example: Consignment arrangement

X Ltd manufactures cars and supplies them to dealers on a consignment basis.
Either party can require the return of a car to the manufacturer within a period of six
months from delivery.
The dealers are required to pay a monthly charge for the facility to display the car.
X Ltd uses this monthly charge to pay for insurance cover and carriage costs.
Legal title to cars held on consignment pass to the dealer when the car is sold to an
end customer (so that title can be passed to the customer).
At the end of six months the dealer must pay X Ltd the trade price as at the date of
delivery or return the car.
Revenue recognition
Control of a car passes at the end of six months (unless it is returned by the dealer)
or when the car is sold.
Revenue is recognised accordingly.

Financial reporting
6 CHAPTER REVIEW
Explain the core principle and the five step approach to revenue recognition
Apply the five step approach to revenue recognition
Explain and apply the rules on variable consideration
Explain how the existence of a significant financing components affects revenue
recognition
Account for contract costs
Explain the required accounting treatment in a series of specific areas

CHAPTER
Contents
Inventory
Measurement of inventory
FIFO and weighted average cost methods
Chapter review

Financial reporting
INTRODUCTION
Aim
principles.
Detailed syllabus
statements
5 Inventories and revenue from contracts (IAS 2, IAS 41, IFRS 15)
Calculate where necessary, discuss and account for inventories and revenue
from contracts in accordance with the provisions of relevant accounting
standards (IAS 2, IAS 41 and IFRS 15).
Exam context
This chapter explains the IAS 2 requirements on accounting for inventories.

„ Define inventory
„ Measure inventory at the lower of cost and net realizable value
„ Use cost formulas to arrive at an approximation to the cost of inventory
„ Explain how inventory valuation impacts profit or loss for the period

Chapter 6: IAS 2: Inventories
1 INVENTORY
Definition of inventory
Periodic inventory system (period end system) – summary
Perpetual inventory method
Summary of journal entries under each system
Inventory counts (stocktakes)
Disclosure requirements for inventory
1.1 Definition of inventory

The nature of inventories varies with the type of business. Inventories are:
‰ Assets held for sale. For a retailer, these are items that the business sells –
its stock-in trade. For a manufacturer, assets held for sale are usually
referred to as ‘finished goods’
‰ Assets in the process of production for sale (‘work-in-progress’ for a
manufacturer)
‰ Assets in the form of materials or supplies to be used in the production
process (‘raw materials’ in the case of a manufacturer).
IAS 2: Inventories sets out the requirements to be followed when accounting for
inventory.
Recording inventory
In order to prepare a statement of profit or loss it is necessary to be able to
calculate gross profit. This requires the calculation of a cost of sales figure.
There are two main methods of recording inventory so as to allow the calculation
of cost of sales.
‰ Periodic inventory system (period end system)
‰ Perpetual inventory system
Each method uses a ledger account for inventory but these have different roles.
1.2 Periodic inventory system (period end system) – summary

Opening inventory in the trial balance (a debit balance) and purchases (a debit
balance) are both transferred to cost of sales.
This clears both accounts.
Closing inventory is recognised in the inventory account as an asset (a debit
balance) and the other side of the entry is a credit to cost of sales.
Cost of sales comprises purchase in the period adjusted for movements in
inventory level from the start to the end of the period.

Financial reporting
Year 1 Year 2
Opening inventory (a debit)

Purchases (a debit) X X
X X
Closing inventory (a credit) (X) (X)
Cost of sales X X
Any loss of inventory is automatically dealt with and does not require a special
accounting treatment. Lost inventory is simply not included in closing inventory
and thus is written off to cost of sales. There might be a need to disclose a loss
as a material item of an unusual nature either on the face of the incomes
statement or in the notes to the accounts if it arose in unusual circumstances
1.3 Perpetual inventory method

This is a system where inventory records are continuously updated so that
inventory values are always available.
A single account is used to record all inventory movements. The account is used
to record purchases in the period and inventory is brought down on the account
at each year-end. The account is also used to record all issues out of inventory.
These issues constitute the cost of sales.
When the perpetual inventory method is used, a record is kept of all receipts of
items into inventory (at cost) and all issues of inventory to cost of sales.
Each issue of inventory is given a cost, and the cost of the items issued is either
the actual cost of the inventory (if it is practicable to establish the actual cost) or a
cost obtained using a valuation method.
Each receipt and issue of inventory is recorded in the inventory account. This
means that a purchases account becomes unnecessary, because all purchases
are recorded in the inventory account.
All transactions involving the receipt or issue of inventory must be recorded, and
at any time, the balance on the inventory account should be the value of inventory
currently held.

Example:
The following entries are necessary during the period.
Inventory account
N N
Balance b/d 10,000 Cost of sales 28,000
Cash or creditors
(purchases in the year) 30,000
Closing balance c/d 12,000

40,000 40,000
Opening balance b/d 12,000
Furthermore, all transactions involving any kind of adjustment to the cost of

inventory must be recorded in the inventory account.
Example:
Limited
returned to a supplier. One of the purchases in the above amount was subject to
an in
above amount.
damaged whilst being handled by GR’s staff.

The following entries are necessary during the period.
Inventory account
N N
Balance b/d 100,000
Cash or creditors Returns to supplier 18,000
(purchases in the year) 500,000
Special freight charge 15,000
Returns from customers 20,000 Cost of goods sold 500,000
Normal loss 5,000
635,000 635,000

Financial reporting
Inventory cards
The receipts and issues of inventory are normally recorded on an inventory
ledger card (bin card). In modern systems the card might be a computer record.
Example: Inventory ledger card

On1January accompany had an opening inventory of 100 units.
During the month it made the following purchases:
5 April: 300 units
14 July: 500 units
22 October: 200 units
During the period it sold 800 units as follows:
9 May: 200 units

25 July: 200 units
23 November: 200 units
12 December:200 units
Each of these can be shown on an inventory ledger card as follows:
Receipts Issues Balance

(units) (units) (units)
Date Units Units Units
1 January b/f 100 100
5 April (purchase) 300 300
400
9 May (issue) 200 (200)
200
14 July (purchase) 500 500
700
25 July (issue) 200 (200)
500
22 Oct (purchase) 200 200
700
23 November (issue) 200 (200)
500
12 December (issue) 200 (200)
1,100 800 300
Inventory ledger cards also usually record cost information. This is covered in
section 3 of this chapter.

1.4 Summary of journal entries under each system
Periodic inventory Perpetual inventory

Entry
method method
Opening inventory Closing inventory as Closing balance on the
measured and inventory account as at
recognised brought the end of the previous
forward from last period period
Purchase of inventory Dr Purchases Dr Inventory
Cr Payables/cash Freightpai Cr Payables/cash
Dr Carriageinwards Dr Inventory
Cr Payables/cash Cr Payables/cash
Return of inventory to Dr Payables Dr Payables

supplier Cr Purchase returns Cr Inventory
Sale of inventory Dr Receivables Dr Receivables

Cr Sales Cr Sales
and
Dr Cost of goods sold
Cr Inventory
Return of goods by a Dr Sales returns Dr Sales returns
supplier Cr Receivables Cr Receivables
and
Dr Inventory
Cr Cost of goods sold
Normal loss Nodouble entry Dr Cost of goods sold
Cr Inventory
Abnormal loss Dr Abnormal loss Dr Abnormal loss
Cr Purchases Cr Inventory
Closing inventory Counted, valued and Balance on the inventory
recognisedby: account
Dr Inventory (statement
of financial position)
Cr Cost of sales (cost of goods sold)
1.5 Inventory counts (stocktakes)
A stock take is a physical verification of the amount of inventory that a business

has.
Each item of inventory is counted and entered onto inventory sheets. The
inventory counted can then be valued.
Periodic inventory systems

Inventory counts are vital for the operation of the periodic inventory system as it
depends on the closing inventory at the end of each period being recognised in
the system of accounts.
Financial reporting
Perpetual inventory systems

Inventory counts are also important to the operation of perpetual inventory systems
as the identify differences between the balance on the inventory account (the
inventory that should be there) and the actual physical quantity of inventory.
The inventory account must be adjusted for any material difference.
Any difference should be investigated. Possible causes of difference between the
balance on the inventory account and the physical inventory counted include the
following.
– Theft ofinventory.
– Damage to inventory with failure to record that damage.
– Mis-posting of inventory receipts or issues (for example posting component
A as component B).
– Failure to record a receipt.
– Failure to record an issue.
Timing of inventory counts

Ideally the inventory count takes place on the last day of an accounting period (the
reporting date). However, this is not always possible due to the day on which the
last day of the accounting period falls or perhaps, not having enough employees
to count the inventory at all sites at the same time.
If the inventory is counted at a date that differs from the reporting date the
balance must be adjusted for transactions between the two dates.
Example: Timing of inventory counts

Sokoto Trading has a 31 December year end. It carried out an inventory count on
The following transactions took place between the 31 December and 5 January.
for
for
The inventory at the reporting date is calculated as follows:
Inventory on 5 January 2,800,000

Add back cost of inventory sold since 31 December 96,000
Deduct purchase since 31 December (136,000)
Inventory at 31 December 2,760,000

1.6 Disclosure requirements for inventory

IAS 2 requires the following disclosures in notes to the financial statements.
▪ The accounting policy adopted for measuring inventories, including the cost
measurement method used.
▪ The total carrying amount of inventories, classified appropriately. (For a
manufacturer, appropriate classifications will be raw materials, work-in-
progress and finished goods.)
▪ The amount of inventories carried at net realisable value or NRV.
▪ The amount of inventories written down in value, and so recognised as an
expense during the period.
▪ Details of any circumstances that have led to the write-down of inventories
to NRV.
▪ The amount of any reversal of any write-down that is recognized as a
reduction in the amount of inventories recognized as expense in the period.
▪ The circumstances or events that led to the reversal of a write-down of
inventories.

Financial reporting
2 MEASUREMENT OF INVENTORY
Section overview
„ Introduction
„ Cost of inventories
„ Net realisable value
„ Accounting for a write down
2.1 Introduction
The measurement of inventory can be extremely important for financial reporting,
because the measurements affect both the cost of sales (and profit) and also
total asset values in the statement of financial position.
There are several aspects of inventory measurement to consider:
▪ Should the inventory be valued at cost, or might a different measurement
be more appropriate?
▪ Which items of expense can be included in the cost of inventory?
▪ What measurement method should be used when it is not practicable to
identify the actual cost of inventory?
IAS 2 gives guidance on each of these areas.
Measurement rule
IAS 2 requires that inventory must be measured in the financial statements at the
lower of:
– cost, or
– net realisable value (NRV).
The standard gives guidance on the meaning of each of these terms.
2.2 Cost ofinventories

IAS2 states that ‘the cost of inventories shall comprise all costs of purchase,
costs of conversion and other costs incurred in bringing the inventories to their
present location and condition.
Purchase cost
The purchase cost of inventory will consist of the following:
– the purchase price
– plus import duties and other non-recoverable taxes (but excluding
recoverable sales tax)
– plus transport, handling and other costs directly attributable to the purchase
(carriage inwards), if these costs are additional to the purchaseprice.
The purchase price excludes any settlement discounts and is the cost after
deduction of trade discount.

Example: Purchase cost I
It has recently taken delivery of 1,000 units of component X.

but
trade discount of 5% due to the size of the order.
The supplier offers an early settlement discount of 2% for payment within 30 days
and KCE intends to achieve this.
Import must
custom.
Once the goods are released through customs KCE must pay a delivery cost of
taken
Purchase price (1,000u N1,200u 95%) 1,140,000

Import duties(1,000u N60) 60,000
Delivery cost 5,000
Cost of inventory 1,205,000
The intention to take settlement discount is irrelevant.
Conversion costs
When materials purchased from suppliers are converted into another product in a
manufacturing or assembly operation, there are also conversion costs to add to
the purchase costs of the materials. Conversion costs must be included in the cost
of finished goods and unfinished work in progress.
Conversion costs consist of:
– costs directly related to units of production, such as costs of direct labour
(i.e. the cost of the labour employed to perform the conversion work)
– fixed and variable production overheads, which must be allocated to costs
of items produced and closing inventories. (Fixed production overheads
must be allocated to costs of finished output and closing inventories on the
basis of the normal production capacity in the period)
– other costs incurred in bringing the inventories to their present location and
condition.
You may not have studied cost and management accounting yet but you need to
be aware of some of the costs that are included in production overheads (also
known as factory overheads). Production overheads include:
– costs of indirect labour, including the salaries of the factory manager and
factory supervisors
– depreciation costs of non-current assets used in production
– costs of carriage inwards, if these are not included in the purchase costs of
the materials
Only production overheads are included in costs of finished goods inventories and
work-in-progress. Administrative costs and selling and distribution costs must not
be included in the cost of inventory.

Financial reporting
Note that the process of allocating costs to units of production is usually called
absorption. This is usually done by linking the total production overhead to some
production variable, for example, time, wages, materials or simply the number of
units expected to be made.
Kaduna Consumer Electrics (KCE) manufactures control units for airconditioning

systems.
The following information is relevant:
Each control unit requires the following:
materials
The company faces the following monthly expenses: N

Factory rent 16,500
Energy cost 7,500
Selling and administrative costs 10,000
Each unit takes two hours to assemble. Production workers are paid
Production overheads are absorbed into units of production using an

hourly rate. The normal level of production per month is 1,000 hours.
The cost of a single control unit is as follows: N

Materials:
Component X 1,205
Component Y 800
Sundry raw materials 150
2,155
Labour ( 2 hours u N300) 600
Production overhead (N16,500+7,500/1,000hours u 2 hours) 48
2,803
These lling and administrative costs are not part of the cost of inventory

Normal production capacity

Production overheads must be absorbed based on normal production capacity
even if this is not achieved in a period.
If production capacity is unusual in a particular period the overhead might be
under or over absorbed.
Example: Normal production capacity

for
The normal level of production is 100,000 units per annum.
Due to supply difficulties the business was only able to make 75,000 units in
the current year.
The cost per unit is: N

Other costs 126
Production overhead (N1,000,000/100,000units) 10
Unit cost 136
Note: N
The amount absorbed intoinventory is (75,000 u N10) 750,000
Total production overhead 1,000,000
The amount not absorbed into inventory 250,000
not in
recognized in the statement of profit or loss).

Financial reporting
2.3 Net realisable value
Definition
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.
Net realisable value is the amount that can be obtained from selling the inventory
in the normal course of business, less any further costs that will be incurred in
getting it ready for sale or disposal.
– Net realisable value is usually higher than cost. Inventory is therefore
usually valued at cost.
– However, when inventory loses value, perhaps because it has been
damaged or is now obsolete, net realisable value will be lower than cost.
The cost and net realisable value should be compared for each separately
- identifiable item of inventory, or group of similar inventories, rather than for
inventory in total.
Example:
A business has four items of inventory. Acount of the inventory has established
that the amounts of inventory currently held, at cost, areas follows:
Cost Sales price Selling costs

Inventory item A1 8,000 7,800 500
Inventory item A2 14,000 18,000 200
Inventory item B1 16,000 17,000 200
Inventory item C1 6,000 7,500 150
The value of closing inventory in the financial

statements:
N
A1 8,000 or (7,800 – 500) 7,300
A2 14,000 or (18,000 – 200) 14,000
B1 16,000 or (17,800 – 500) 16,000
C1 6,000 or (7,000 – 200) 6,000
Inventory measurement 43,300
Net realisable value might be lower than cost so that the cost of inventories may
not be recoverable in the following circumstances:
– inventories are damaged;
– inventories have become wholly or partially obsolete; or,
– selling prices have declined.

2.4 Accounting for a write down

When the cost of an item of inventory is less than its net realisable value the cost
must be written down to that amount.
Component A1 in the previous example had a carrying value of N8,000 (being its
cost) butits NRV was estimated to be N7,300. The item must be written down to
this amount. How this is achieved depends on circumstance and the type
of inventory accounting system.
Perpetual inventory systems

The situation here is similar to that for inventory loss.
The inventory must be written down in the system by the following journal:
Credit
Costofsales
Inventory
Period end system / Periodic inventory system

If the necessity for the write down is discovered during an accounting period then
no special treatment is needed. The inventory is simply measured at the NRV
when it is included in the year-end financial statements. This automatically
includes the write down in cost of sales.
If the problem is discovered after the financial statements have been drafted (and
before they are finalised) the closing inventory must be adjusted as follows:
Debit Credit
Statement of profit or loss closing inventory (cost
of sales)
Inventory in the statement of financial position

Financial reporting
3 FIFO AND WEIGHTED AVERAGE COST METHODS
Cost formulas
First-in, first-out method of measurement (FIFO)
Weighted average cost (AVCO) method
Profit impact
3.1 Cost formulas

With some inventory items, particularly large and expensive items, it might be
possible to recognise the actual cost of each item.
In practice, however, this is unusual because the task of identifying the actual
cost for all inventory items is impossible because of the large numbers of such
items.
A system is therefore needed for measuring the cost of inventory.
The historical cost of inventory is usually measured by one of the following
methods:
‰ First in, first out (FIFO)
‰ Weighted average cost (AVCO)
Illustration
On 1 January a company had an opening inventory of 100 units which cost N50
each.
5 April: 300 units at N60 each

14 July: 500 units at N70 each
22 October: 200 units at N80 each.
During the period it sold 800 units as
follows: 9 May: 200 units
25 July: 200 units
This means that it has 300 units left (100 + 300 + 500 + 200 – (200 + 200 +
200+200+200) but what did they cost?
FIFO and AVCO are two techniques that provide an answer to this question.
Note:
‰ First in, first out (FIFO) tends to be used in periodic inventory systems but
may be used in perpetual inventory systems also.
‰ Weighted average cost (AVCO) is easier to apply when a perpetual
inventory system is used.

3.2 First-in-first-out method of measurement (FIFO)

With the first-in, first-out method of inventory measurement, it is assumed that
inventory is consumed in the strict order in which it was purchased or
manufactured. The first items that are received into inventory are the first items
that go out.
To establish the cost of inventory using FIFO, it is necessary to keep a record of:
– The date that units of inventory are received into inventory, the number of
units received and their purchase price (or manufacturing cost)
– the date that units are issued from inventory and the number of units
issued.
With this information, it is possible to put a cost to the inventory that is issued
(sold or used) and to identify the cost of the items still remaining in inventory.
Since it is assumed that the first items received into inventory are the first units
that are used, it follows that the value of inventory at any time should be the cost
of the most recently-acquired units of inventory.

Financial reporting
Example: FIFO (returning to the previous example)

each.
5 April: 300 units at N60 each (= N18,000)
14 July: 500 units at N70 each (=N35,000)
22 October: 200 units at N80 each (= N16,000)
9 May: 200 units
25 July: 200 units
The cost of each material issue from store in October and the closing inventory
using the FIFO measurement method is as follows:
FIFO measures inventory as if the first inventory sold is always the first
inventory purchased.
Consider the flow of units:
Bf 5 14 22
April July October
(units) (units) (units) (units)
Purchased 100 300 500 200
Issues on:
9 May (200) (100) (100)
25 Jul (200) (200)
23 Nov (200) (200)
12 Dec (200) (200)
Closing inventory – – 100 200

Example (continued): Measurement

Issues on 9 May Cost perunit N
100 units in opening inventory 50 5,000
100 units purchased on 5 April 60 6,000
Cost of issue 11,000
Issues on 25 July Cost perunit

200 units purchased on 5 April 60 12,000
Issues on 23 November Cost perunit

200 units purchased on 14 July 70 14,000
Issues on 12 December Cost perunit

Closing inventory Cost perunit

200 units purchased on 22 October 80 16,000
23,000
This looks more complicated than it needs to be. This is because the cost of each
individual issue has been calculated. However, usually we would not be interested
in the cost of individual issues so much as the overall cost of sale and closing
inventory. When this is the case the calculations become much easier.
This is because the total costs of buying the inventory are known so only the
closing inventory has to be measured. This is done assuming that it is from the
most recent purchases (because FIFO assumes that the inventory bought earlier
has been sold).
N
Value of opening inventory 5,000
Purchases in the period (18,000+35,000+16,000) 69,000
74,000
Value of closing inventory (31 December)
(23,000)
Cost of materials issued in October 51,000

Financial reporting
Inventory ledger card

The purchases and issues can be recorded on an inventory ledger card as follows:
Example: Inventory ledger card (FIFO)

Date Qty @ N Qty @ N Qty @ N
1 Jan
b/f 100 50 5,000 100 50 5,000
5 Apr 300 60 18,000 300 60 18,000
400 50/60 23,000
9 May 100 50 5,000 100 50 5,000
100 60 6,000 100 60 6,000
200 50/60 11,000 (200) 50/60 (11,000)
200 60 12,000
14 Jul 500 70 35,000 500 70 35,000
700 60/70 47,000
25 Jul 200 60 12,000 (200) 60 12,000
500 70 35,000
22 Oct 200 80 16,000 200 80 16,000
700 70/80 51,000
23 Nov 200 70 14,000 (200) 70 (14,000)
500 70/80 37,000
12 Dec 200 70 14,000 (200) 70 (14,000)
1,100 74,000 800 51,000 300 70/80 23,000
Note: 1,100 minus 800 equals 300
74,000 minus 51,000 equals 23,000

3.3 Weighted average cost (AVCO) method

With the weighted average cost (AVCO) method of inventory measurement it is
assumed that all units are issued at the current weighted average cost per unit.
A new average cost is calculated whenever more items are purchased and
received into store. The weighted average cost is calculated as follows:
Cost of inventory currently in store +

Cost of new items received
= New weighted average
Number of units currently in store +
Number of new units received
Items ‘currently in store’ are the items in store immediately before the new
delivery is received.
Example: FIFO (returning to the previous example)

each.
5 April: 300 units at N60 each (= N18,000)
14 July: 500units at N70 each (= N35,000)
22 October: 200 units at N80 each (= N16,000)
9 May: 200 units
25 July: 200 units
12 December: 200 units
Required
(a) What was the cost of the material issued from store in the year, using the
weighted average cost (AVCO) measurement method?
(b) What was the value of the closing inventory on 31 December?

Financial reporting
The weighted average method calculates a new average cost per unit after each
purchase. This is then used to measure the cost of all issues up until the next
purchase.
This can be shown using an inventory ledger card as follows:
Example: Inventory ledger card (weighted average method)

Date Qty @ N Qty @ N Qty @ N
1 Jan
b/f 100 50 5,000 100 50 5,000
5Apr 300 60 18,000 300 60 18,000
400 57.5 23,000
9May 200 57.5 11,500 (200) 57.5 (11,500)
200 57.5 11,500
14Jul 500 70 35,000 500 70 35,000
700 66.43 46,500
25Jul 200 66.43 13,286 (200) 66.43 (13,286)
500 66.43 33,214
22Oct 200 80 16,000 200 80 16,000
700 70.31 49,214
23Nov 200 70.31 14,062 (200) 70.31 (14,062)
500 70.31 35,152
12Dec 200 70.31 14,062 (200) 70.31 (14,062)
1,100 74,000 800 52,910 300 70/80 21,090
Figures in bold have been calculated as an average cost at the date of a purchase.
Note: 1,100 minus 800 equals 300
74,000 minus 52,910 equals 21,090
Value of opening inventory,1 5,000

October
Purchases in the period 69,000
74,000
Value of closing inventory, 31 October (see above) (21,090)

Cost of materials issued in October
(See figures above: 11,500 + 13,286 + 14,062+ 14,062) 52,910

3.4 Profit impact

Inventory valuation has a direct effect on profit measurement.
Under the periodic inventory system closing inventory is credited to cost of sales.
If the value of closing inventory is increased by N100 then profit would increase by
the same amount.
Under the perpetual inventory system cost of sales is comprised of the transfers
from the inventory account and the closing inventory is the balance on the
account. However, if the closing inventory balance is changed for whatever
reason (say because of a difference between the closing inventory on the account
and the actual closing inventory measured) the difference impacts cost of sales
and hence gross profit. In other words profit is affected by the value assigned to
closing inventory.
The figures derived from the cost formula examples above can be used to
demonstrate the profit impact of different inventory value.
Example: Profit impact of inventory valuation

in
N N
Sales 100,000 100,000
Cost of sales:
Opening inventory 5,000 5,000
Purchases 69,000 69,000
74,000 74,000
Closing inventory:
FIFO (23,000)
AVCO (21,090)
Cost of sales (51,000) (52,910)
Gross profit 49,000 47,810
The profit difference is entirely due to how closing inventory is

measured under each system.

Financial reporting
4 CHAPTER REVIEW
Define inventory
Measure inventory at the lower of cost and net realizable value
Use cost formulas to arrive at an approximation to the cost of inventory
Explain how inventory valuation impacts profit or loss for the period

CHAPTER
Contents
Initial measurement of property, plant and equipment
Depreciation and carrying amount
Revaluation of property, plant and equipment
Derecognition of property, plant and equipment
Disclosure requirements of IAS16
Questions
Chapter review

Financial reporting
INTRODUCTION
Aim
principles.
Detailed syllabus
Accounting standards and policies relating to specific transactions in financial
B
statements
1 Tangible non-current assets (IAS 16)
Calculate, where necessary, discuss and account for tangible non-current assets
in accordance with the provisions of relevant accounting standards (IAS 16, IAS
20, IAS 23, IAS 40, and IFRS 5).
IAS 16 is an examinable document

Exam context
This chapter explains rules on accounting for property plant and equipment

▪ Measure property, plant and equipment on initial recognition
▪ Measure property, plant and equipment after initial recognition using the cost model
and the revaluation model
▪ Account for disposals of property plant andequipment
▪ Construct basic notes to the financial statements in respect of property plant and
equipment

Chapter 7: IAS 16: Property, plant and equipment
1 INITIAL MEASUREMENT OF PROPERTY, PLANT AND EQUIPMENT
Introduction
Initial measurement
Exchange transactions
Elements of cost
Subsequent expenditure
Measurement after initial recognition
1.1 Introduction
Rules on accounting for property, plant and equipment are contained in IAS 16:
Property, plant and equipment.
Definition
Definition: Property, plant and equipment

Property, plant and equipment are tangible items that:
(a) are held for use in the production or supply of goods or services, for
rental to others, or for administrative purposes; and
(b) are expected to be used during more than one period.
Items such as spare parts, stand-by equipment and servicing equipment are
recognised as property, plant and equipment when they meet the above
definition. If this is not the case they are recognised as inventory.
Initial recognition
The cost of an item of property, plant and equipment must be recognised as an
asset if, and only if:
– it is probable that future economic benefits associated with the item will flow
to the entity; and
– the cost of the item can be measured reliably.
Items of property, plant and equipment may be acquired for safety or
environmental reasons. At first sight it looks as if such items would not be
recognised as property, plant and equipment according to the recognition criteria
because they do not directly increase future economic benefits. However, they
may be necessary in order that a company obtain the future economic benefits
from its other assets so they do qualify for recognition.

Financial reporting
Illustration:
A chemical manufacturer may install new chemical handling processes to comply
with environmental requirements for the production and storage of dangerous
chemicals.
This would be recognized as an asset because without them the company cannot
make and sell chemicals.
1.2 Initial measurement

Property, plant and equipment are initially recorded in the accounts of a business
at their cost.
Definition: Property, plant and equipment

Cost is 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 at tribute to that asset when initially recognised in
accordance with the specific requirements of other IFRSs.
The cost of an item of property, plant and equipment is the cash price equivalent
at the recognition date. If payment is deferred beyond normal credit terms, the
difference between the cash price equivalent and the total payment is recognised
as interest over the period of credit unless it is capitalised in accordance with IAS
23: Borrowing costs (covered later).

Example: Deferred consideration

A company buys a machine on 1 January 20 X 7.
for
machine on 31 December 20 X 7 (1 year later).
An appropriate discount rate is 6%
1 January 20 X 7 – Initial recognition

Initial measurement of the 1
purchase price =
Debit Credit
Property, plant and equipment
Liability 4,716,981
31 December 20 X 7 – Date of payment
Debit Credit
Statement of profit or loss 283,019
Liability
Balance on the liability Balance

brought forward 4,716,981
Interest expense recognised in the period 283,019
5,000,000
Cash/bank (5,000,000)

Financial reporting
1.3 Exchange transactions

An asset may be acquired in exchange for another asset. The cost of such asset
is measured at its fair value unless:
– the exchange transaction lacks commercial substance; or
– the fair value of neither the asset received nor the asset given up is reliably
measurable.
If the new asset is measured at fair value, the fair value of the asset given up is
used to measure the cost of the asset received unless the fair value of the asset
received is more clearly evident.
If the new asset is not measured at fair value, its cost is measured at the carrying
amount of the asset given in exchange for it. This would be the case when the
exchange lacked commercial substance or when the fair value of either asset
cannot be measured.
Lack of commercial substance
The determination of whether an exchange transaction has commercial
substance depends on the extent to which future cash flows are expected to
change as a result of the transaction. If there is minimal impact on future cash
flows then the exchange lacks commercial substance.
1.4 Elements of cost

The definition of ‘cost’ for property, plant and equipment has close similarities
with the cost of inventories, although property, plant and equipment will often
include more items of ‘other expense’ within cost.
The cost of an item of property, plant and machinery consists of:
▪ its purchase price after any trade discount has been deducted, plus any
import taxes or non-refundable sales tax; plus
▪ the directly attributable costs of bringing the asset to the location and
condition necessary for it to be capable of operating in the manner intended
by management. These directly attributable costs may include:
x employee costs arising directly from the installation or construction of
the asset;
x the cost of site preparation;
x delivery costs (‘carriage inwards’);
x installation and assembly costs;
x testing costs to assess whether the asset is functioning properly (net
of sale proceeds of items produced during the testing phase).
x professional fees directly attributable to the purchase.
‰ When the entity has an obligation to dismantle and remove the asset at the
end of its life, its initial cost should also include an estimate of the costs of
dismantling and removing the asset and restoring the site where it is located.
This will be explained in more detail in chapter 13 which covers IAS 37:
Provisions, contingent liabilities and contingent assets.

A company has purchased a large item of plant. The

following costs were incurred.
List price of the machine 1,000,000

Trade discount given 50,000
Delivery cost 100,000
Installation cost 125,000
Cost of site preparation 200,000
Architect’s fees 15,000
Administration expense 150,000
Test run cost 75,000
The test run cost was to ensureth at the asset was installed and working
correctly. Items of inventory were produced during the test run. These
Local government officials have granted the company a license to operate

the asset on condition that the company will remove the asset and return the
site to its former condition at the end of the asset’s life.
in expected
clearance cost.
The cost of the asset is as follows:
N
Purchase price of the machine (1,000,000 – 50,000) 950,000
Delivery cost 100,000
Installation cost 125,000
Cost of site preparation 200,000
Architect’s fees 15,000
Decommissioning cost 250,000
Test run cost (75,000 –10,000) 65,000
1,705,000
The recognition of costs ceases when the asset is ready for use. This is when it
is in the location and condition necessary for it to be capable of operating in the
manner intended by management.
Cost of self-constructed assets

The cost of a self-constructed asset is determined using the same principles as
for an acquired asset.
A company might make similar assets for sale in the normal course of business.
The cost of an asset for the company to use itself would normally be the same as
the cost of an asset for sale as measured according to IAS 2: Inventories.
IAS23: Borrowing costs, deals with whether interest costs on borrowing to
finance the construction of a non-current asset should be included in the cost of
the asset. This is covered in the next chapter.

Not part of cost
Only those costs necessary to bring an asset to a condition and location where it
is capable of operating in the manner intended by management are recognised.
IAS 16 provides the following list of costs that are not costs of an item of
property, plant and equipment:
▪ costs of opening a new facility;
▪ costs of introducing a new product or service (including costs of advertising
and promotional activities);
▪ costs of conducting business in a new location or with a new class of
customer (including costs of staff training); and
▪ administration and other general overhead costs.
1.5 Subsequent expenditure

Expenditure relating to non-current assets, after their initial acquisition, should be
capitalised if it meets the criteria for recognising an asset.
In practice, this means that expenditure is capitalised if it:
▪ improves the asset (for example, by enhancing its performance or
extending its useful life); or
▪ is for a replacement part (provided that the part that it replaces is treated as
an item that has been disposed of).
Repairs and maintenance expenditure is revenue expenditure. It is recognised as
an expense as it is incurred, because no additional future economic benefits will
arise from the expenditure.
A basic rule is that improvements are capitalised but repairs are expensed. You
may have to correct situations when an amount spent has not been treated
correctly. This is covered in section 6 of this chapter.
Major inspections
A company might only be allowed to operate some assets if those assets are
subject to regular major inspections for faults.
The cost of such major inspections is recognised in the carrying amount of the
asset as a replacement if the recognition criteria are satisfied.
When a major inspection is carried out any remaining carrying amount of the cost
of the previous inspection is derecognised.

Example: Major overhaul

A shipping company is required to put its ships into dry dock every three years
for an overhaul, at a cost of N3,000,000. The ships have a useful life of 20 years.
A ship is purchased from a ship builder at a cost of N200 million.
Initial recognition
N3,000,000 of the asset cost should be treated as a separate component and
depreciated over three years.
There stof the cost of the ship (N197million) should be depreciated over 20 years.
End of year 3
An overhaul is required.
The cost of the overhaul is capitalised and added to the asset’s cost.
The cost (N3,000,000) and accumulated depreciation of the depreciated
component is removed from the accounts.
1.6 Measurement after initial recognition

IAS 16 allows a choice of accounting treatments after initial recognition.
All items of property, plant and equipment in a class can be accounted for using
one of two models:
▪ Cost model - Property, plant and equipment is carried at cost less any
accumulated depreciation and any accumulated impairment losses.
▪ Revaluation model - Property, plant and equipment is carried at a revalued
amount. This is the fair value at the date of the revaluation less any
subsequent accumulated depreciation and any accumulated impairment
losses.
The above choice must be applied consistently. A business cannot carry one item
of property, plant & equipment at cost and revalue a similar item. However, a
business can use different models for different classes of property, plant &
equipment. For example, companies might use the cost model for plant and
equipment but use the revaluation model forproperty.
Depreciation is an important component of both models.

Financial reporting
2 DEPRECIATION AND CARRYING AMOUNT
Depreciation
Depreciable amount and depreciation period
Reviews of the remaining useful life and expected residual value
Depreciation method
Review of depreciation method
Impairment
You should be familiar with the measurement and recognition of depreciation

from your previous studies. This section provides a reminder of the key concepts.
2.1 Depreciation
Depreciation is an expense that matches the cost of a non-current asset to the
benefit earned from its ownership. It is calculated so that a business recognises
the full cost associated with a non-current asset over the entire period that the
asset is used.
Definitions
Depreciation is the systematic allocation of the depreciable amount of an asset
over its useful life.
Depreciable amount is the cost of an asset, or other amount substituted for cost,
less its residual value.
The residual value of an asset is the estimated amount that an entity would
currently obtain from disposal of the asset, after deducting the estimated costsof
disposal, if the asset were already of the age and in the condition expected at the
end of its useful life.
Useful life is:
(a) the period over which an asset is expected to be available for use by an
entity; or
(b) the number of production or similar units expected to be obtained from the
asset by anentity.
Carrying amount is the amount at which an asset is recognized after deducting
any accumulated depreciation and accumulated impairment losses. (Net book
value (NBV) is a term that is of ten used instead of carrying amount).

Parts of an asset
Each part of an asset that has a cost that is significant in relation to the total cost
of the item must be depreciated separately. This means that the cost of an asset
might be split into several different component assets and each depreciated
separately.
for
The company has identified the following cost components and useful lives in
respect of this jet.
Engines 2,000 3 years

Airframe 1,500 10 years
1,500 20 years
Fittings 5 years
5,500
Depreciation is charged as an expense in the statement of profit or loss each year

over the life of the asset unless it relates to an asset being used to construct
another asset. In this case the depreciation is capitalised as part of the cost of that
other asset in accordance with the relevant standard (For example: IAS 2:
Inventories; IAS 16 Property, plant and equipment; IAS 38; Intangible assets).
Accounting for depreciation
The double entry for depreciation should be familiar to you from your earlier
studies. This section gives a brief recap.
Illustration: Depreciation double entry

Debit Credit
Depreciation expense X
Accumulated depreciation X
The balance on the depreciation expense account is taken to the statement of

profit or loss as an expense for the period.
The non-current asset figure in the statement of financial position is made up of
two figures, the cost less accumulated depreciation.
Illustration: Carrying amount of a non-current asset

N
Non-current asset at cost X
Less accumulated depreciation (X)
This figure appears on the
face of the statement of
Carrying amount (net book value) X financial position

Financial reporting
2.2 Depreciable amount and depreciation period

The depreciable amount of an asset must be allocated on a systematic basis
over its useful life.
Commencement of depreciation
Depreciation of an asset begins when that asset is available for use. This means
when the asset is in the location and condition necessary for it to be capable of
operating in the manner intended by management. This might be before the asset
is actually used.
Cessation of depreciation
Depreciation ends at the earlier of when an asset is classified as held for sale in
accordance with IFRS 5: Non-current assets held for sale and discontinued
operations and when it is derecognised.
Depreciation does not cease when an asset becomes idle or is withdrawn or
retired from active use.
Residual value
In practice, the residual value of an asset is often insignificant and therefore
immaterial in the calculation of the depreciable amount.
However, in some cases, the residual value may be equal to or greater than the
asset's carrying amount. In this case the depreciation charge would be zero.
Land and buildings
Land and buildings are separable assets and are dealt with separately for
accounting purposes, even when they are acquired together.
Land normally has an unlimited life and is therefore not depreciated. However,
there are exceptions to this. If land has a physical attribute that is used over a
period then the land should be depreciated over this period.
Example: Land
Okene Quarries has purchased as Its from which they will extract grave lf or sale
to the construction industry.
The site cost N50,000,000.
It is estimated that gravel will be extracted from the site over the next
20years. The land must be depreciated over 20years.
Buildings normally have a limited life and are therefore depreciable assets.

Chapter 7: IAS 16: Property, plant andequipment
2.3 Reviews of the remaining useful life and expected residual value
Review of useful life
IAS 16 requires useful lives and residual values to be reviewed at each year-end.
Any change is a change in accounting estimate. The carrying amount (cost minus
accumulated depreciation) of the asset at the date of change is written off over
the (revised) remaining useful life of the asset.
Example:
Benin City Engineering owns a machine which originally cost N60,000 on 1
January 20 X 3.
The machine was being depreciated over its usefull life of 10 years on a
straight- line basis and has no residual value.
On 31 December 20 X 6 Benin City Engineering revised the total useful
Life for the machine to eight years (down from the previous10).
Required
Calculate the depreciation charge for 20X6 and subsequent years.
The change in accounting estimate is made at the end of 20X6 but may be applied
to the financial statements from 20X6 onwards.
Coston 1 January 20 X 3 60,000

Depreciation for 20 X 3 to 20X5 (60,000×3/10) (18,000)
–––––––
Carrying amount at end of 20 X 5 42,000
–––––––
Remaining useful life at the end of 20X5 = 8 – 3 years = 5 years.

for = =
Residual value
The residual value of an item of property, plant and equipment must be reviewed
at least at each financial year end and if expectations differ from previous
estimates the depreciation rate for the current and future periods is adjusted.
A change in the asset’s residual value is accounted for prospectively as an
adjustment to future depreciation.
Practice question
A machine was purchased three years ago on 1 January Year 2. It cost
Due to technological changes, the estimated life of the asset was re- assesse
during Year 5. The total useful life of the asset is now expected to be 7 years
and the machine is now considered to have no residual value.
The financial year of the entity ends on 31 December.
What is the depreciation charge for the year ending 31 December Year 5?

Financial reporting
2.4 Depreciation method

The depreciation method used should reflect the way in which the economic
benefits of the asset are consumed by the business over time.
The main choice is between the straight line method and the reducing balance
method (also known as the diminishing balance method).
Straight-line method
The depreciable amount is charged in equal amounts to each reporting period

over the expected useful life of the asset.
Depreciation charge Cost of asset less expected residual value
=
For the year Expected useful life (years)
The charge in the first and last year is time apportioned.
Example: Straight line depreciation – mid-year acquisition
It is expected that the machine will have a zero scrap value at the end of its useful
life.
The machine was bought on the 1st September and the company has a 31st
December year end.
The depreciation charge in the first year of ownership is:
Depreciation charge = = N
5 years

Reducing balance method
Definition: Reducing balance method

The annual depreciation charge is a fixed percentage of the carrying amount of
the asset at the start of the period.
Depreciation charge Carrying amount Fixed

=
for theyear at the start of
theyear
Example: Reducing balance method
The company has a 31 December year end.

It has an expected life of five years, and it is to be depreciated by the reducing balance
method at the rate of 30% each year.
Annual depreciation and carrying amount over the life of the asset will be as follows.
Carrying Annual Carrying

amountat depreciation amountat
Year start charge end
N N N N
1 100,000 u30%u3/12 7,500 92,500
2 92,500 u30% 27,750 64,750
3 64,750 u30% 19,425 45,325
4 45,325 u30% 13,598 31,727
Note that the depreciation in the year after the firstfull year’s
depreciation (year 2) can be calculated by multiplying the previous
year’s charge by (1
– the
3 reducing
27,750balance
u70% percentage). 19,425
4 19,425 u70% 13,598
n Residual value
-1
Cost
Where:
x=The reducing balance percentage
n = Expected useful life.

Financial reporting
Example: Reducing balance

its expected u
which is 5years.
The reducing balance percentage is calculated as follows.
Carrying Annual depreciation Carrying

amount atstart charge (at (27.5% amount at end
Year ofyear reducing balance) of year
N N N
1 10,000 2,750 7,250
2 7,250 1,994 5,256
3 5,256 1,445 3,811
4 3,811 1,048 2,763
5 2,763 763 2,000
Note that the depreciation charge in year 5 contains arounding difference of 3.
Depreciation by number of units produced
Definition
Depreciation is calculated by expressing the useful life of an asset in terms of its
expected total output and allocating the annual charge to depreciation based on
actual output.
Cost – residual value Number of units

=
charge produced in period
over the life of the asset

2.5 Review of depreciation method

The depreciation method applied to property, plant and equipment must be
reviewed periodically and, if there has been a significant change in the expected
pattern of economic benefits from those assets, the method is changed to reflect
the changed pattern.
Where there is a change in the depreciation method used, this is a change in
accounting estimate. A change of accounting estimate is applied from the time of
the change, and is not applied retrospectively. The carrying amount (cost minus
accumulated depreciation) of the asset at the date of the change is written off over
the remaining useful life of the asset.
Example:
Oyo Fabrics owns a machine which originally cost N30,000 on 1 January 20 X 3.
It has no residual value.
It was being depreciated over its useful life of 10 years on a straight-line basis.
At the end of 20 X 6, when preparing the financial statements for 20 X 6, Oyo
Fabrics decided to change the method of depreciation, from straight-line to the
reducing balance method, using a rate of 25%.
Required
Calculate the depreciation charge for 20 X 6.
The change in accounting estimate is made at the end of 20 X 6 but is applied

to the financial statements from 1 January 20 X 6.
The reducing balance method of depreciation is applied to the 20 X 6
statements.
Coston1January 20X3 30,000

Depreciation for 20X3 to 20X5 (30,000×3/10) (9,000)
–––––––
Carrying amount at end of 20 X 5 21,000
–––––––
for × =

Financial reporting
2.6 Impairment
Both the cost model and the revaluation model refer to impairment losses.
IAS 36 Impairment of assets contains detailed guidance on impairment.
Definition
Impairment loss: The amount by which the carrying amount of an asset (or a
cash- generating unit) exceeds its recoverable amount.
An impairment loss is a write down in the value of an asset to its recoverable

amount. IAS 36 operates to ensure that assets are carried in the financial
statements at no more than their recoverable amount. (This is very similar to the
rule that requires inventory to be measured at the lower of cost and net realisable
value).
The recoverable amount of an asset is defined as the higher of its:
– Fair value less costs to sell (the amount that would be received for the
asset in an orderly transaction between market participants less costs of
selling it); and
– Value in use (the present value of future cash flows from using an asset,
including its eventualdisposal).
You will not be asked to compute these figures in the exam, but you might be
given the two amounts and be expected to identify the recoverable amount and
account for any impairment loss.
Example: Impairment
The following information relates to 3 assets:
Asset1 Asset 2 Asset 3
Carrying amount 80,000 120,000 140,000
Value in use 150,000 105,000 107,000
Fair value less cost to sell 60,000 90,000 110,000
Recoverable amount 150,000 105,000 110,000
Impairment loss nil 15,000 30,000
Approach
Impairment of an asset should be identified and accounted for as follows:
▪ At the end of each reporting period, a business should assess whether
there are any indications that an asset may be impaired.
▪ If there are such indications, the business should estimate the asset’s
recoverable amount.
▪ When the recoverable amount is less than the carrying amount of the
asset, the carrying amount should be written down to this amount. The
amount by which the value of the asset is written down is an impairment
loss.
▪ This impairment loss is recognised as a loss for the period.
▪ Depreciation charges for the impaired asset in future periods should be
adjusted to allocate the asset’s revised carrying amount, minus any
residual value, over its remaining useful life (revised if necessary).
▪
There is no specific guidance on the double entry needed to record impairment.
One way of accounting for it is to set up an accumulated impairment loss account
and account for it just like depreciation.
3 REVALUATION OF PROPERTY, PLANT AND EQUIPMENT
Revaluation and the entity’s accounting policy

Accounting for revaluation
Changing the carrying amount of a revalued asset
Depreciation of a re-valued asset
Realisation of the revaluation surplus
Revaluation model: the frequency of revaluations
3.1 Revaluation and the entity’s accounting policy

An item of property, plant and equipment is recognised at cost when it is first
acquired.
IAS 16 allows a business to choose one of two measurement models as its
accounting policy for property, plant and equipment after acquisition. The same
model should be applied to all assets in the same class.
The two measurement models for property, plant and equipment after acquisition
are:
– cost model (i.e., cost less accumulated depreciation); and
– revaluation model (i.e., revalued amount less accumulated depreciation
since the most recent revaluation).
For example, a company’s policy might be to value all its motor vehicles at cost,
but to apply the revaluation model to all its land and buildings.
Revaluation model – Issues
The following accounting issues have to be addressed when using the
revaluation model:
Issue
1 What happens to the other side of the entry when the carrying amount of
an asset is changed as a result of a revaluation adjustment?
An asset value may increase or decrease.
What happens in each case?
2 How is the carrying amount of the asset being revalued changed?. The
carrying amount is located in two accounts (cost and accumulated
depreciation) and it is the net amount that must be changed so how is this
done?
3 How often should the revaluation take place?

3.2 Accounting for revaluation

When a non-current asset is revalued, its ‘carrying amount’ in the statement of
financial position is adjusted from carrying amount to its fair value (normally
current market value) at the date of the revaluation.
How the carrying amount is changed will be addressed later. This section
concentrates on the other side of the entry.
Asset carried at cost revalued upwards
An increase in value is credited to other comprehensive income and accumulated
in equity under the heading of revaluation surplus.
Example: Upward revaluation

Land was purchased for 100 on the first day of the 20 X 6 accounting
period. The business revalues land as permitted bythe IAS16.
The land was revalued to 130 at the end of the first year of ownership.
Double entry: IAS 16 Debit Credit

Land 30
Other comprehensive income (and accumulated
in a revaluation surplus). 30
Property, plant and equipment 130
Asset carried at cost revalued downwards

A decrease in value is debited as an expense to the statement of profit or loss.
Example: Downward revaluation

Land was purchased for 100 on the first day of the 20 X 6 accounting
period. The business revalues land as permitted by the IAS 16.
The land was revalued to 90 at the end of the first year of ownership.
Debit Credit
Statement of profit or loss 10
Land 10

Financial reporting
Asset carried at a revaluation deficit is revalued upwards

An asset might be carried at an amount lower than its original cost as a result of
being revalued downwards.
If the asset is later revalued upwards, the revaluation increase is recognised in the
statement of profit or loss to the extent of the previously recognised expense. That
part of any increase above the previously recognised expense is recognised in the
usual way, in other comprehensive income (IAS 16).
Asset carried at a revaluation surplus revalued downwards
An asset might be carried at an amount higher than its original cost as a result of
being revalued upwards.
If the asset is later revalued downwards, the revaluation decrease is recognised
in other comprehensive income to the extent of the previously recognised
surplus. That part of any decrease above the previously recognised surplus is
recognised in the statement of profit or loss the usual way.

Example: Downward revaluation – Accounted for under IAS 16

A business purchased a plot of land on the first day of the 20 X 6 accounting
period. The business applies the IAS 16 revaluation model to the measurement
of land after initial recognition. The business has a policy of revaluing land
annually.
The initial amount recognised and the year end values are shown below:
N
Measurement on initial recognition 100
Valuation as at:
31 December 20X6 130
31 December 20X8 95
The double entries are as follows:

31 December 20X6 Debit Credit
Land (130 – 100) 30
Other comprehensive income 30

Land (110 – 130) 20
The fall in value reverses a previously recognised surplus. It is
recognized in OCI to the extent that it is covered bythe surplus.
Land (95 – 110) 15
The fall in value in part reverses a previously recognised surplus. It
is recognized in OCI to the extent that it is covered by the
surplus.This reduces the revaluation surplus to zero.
Any amount not covered by the surplus is recognised as an expense in
the statement of profit orloss.
31 December 20 X 9 Debit Credit
Land (116 – 95) 21
16
Other comprehensive income arise in value that reverses a previously

recognized expense is recognised in the statement of profit or loss to the
extent that it reverses the expense. Any amount above this is recognised
in other comprehensive income.

Financial reporting
Other
comprehensive Statement of
Land income profit or loss
At start 100 – –
Double entry 30 30Cr
31/12/X6 130
b/f 130
(20) 20Dr
31/12/X7 110
b/f 110
Adjustment (15) 10Dr 5Dr
31/12/X8 95
b/f 95
Adjustment 21 16Cr 5Cr
31/12/X9 116
3.3 Changing the carrying amount of a revalued asset.

In the previous example land was revalued. Land is not depreciated so the
carrying amount of land is represented in a single account. This made it easy to
change:
The carrying amount of depreciable assets is the net of balances on two separate
accounts. The double entry to revalue the asset must take this into account.
IAS 16 allows a choice of two approaches which differ in the treatment of the
accumulated depreciation account.
When an item of property, plant and equipment is revalued, any accumulated
depreciation at the date of the revaluation is treated in one of the following ways:
Method 1
Restate accumulated depreciation proportionately with the change in the gross
carrying amount of the asset so that the carrying amount of the asset after
revaluation equals its revalued amount.
Method 2
Step 1: Transfer the accumulated depreciation to the asset account. The result of
this is that the balance on the asset account is now the carrying amount of the
asset and the accumulated depreciation account in respect of this asset is zero.
Step 2: Change the balance on the asset account to the revalued amount.

Example: Method 1
N N
N
ation this N
Before After
Cost 25 u26/20 32.5
Accumulated depreciation (5) u26/20 (6.5)
Carrying amount 20 u26/20 26
Journals Nm Nm
Asset 7.5
Accumulated depreciation 1.5
Revaluation surplus 6
Example: Method 2
N N
N
ation this N
Step 1 Nm Nm
Accumulated depreciation 5
Asset 5
Step 2
Asset (N26 – N20m) 6
Alternatively this could be done with a single journal:

Asset (N26 – N25m) 1
Before 1 2 After
Cost 25 (5) 6 26
Accumulated depreciation (5) 5 –
Carrying amount 20 26

Financial reporting
Example:
An office building was purchased four years ago for N3 million.
The building has been depreciated by N100,000.
It is now re-valued to 4million.
Show the book-keeping entries to record the revaluation.
Answer
Building account
N N
Opening balance b/f 3,000,000 Accumulated
depreciation 100,000
Other comprehensive
income 1,100,000 Closing balance c/f 4,000,000
4,100,000 4,100,000
Opening balance b/f 4,000,000
Accumulated depreciation of building account

N N
=N = N
Buildingaccount 100,000 Opening balance b/f 100,000
N
Buildingaccount 1,100,000
Tutorial note:
The balance on this account is transferred into a revaluation surplus account as
follows:
N N
=N =N
in N
Revaluation surplus 1,100,000 Building account 1,100,000
N
Revaluation surplus
N N
Other comprehensive
income 1,100,000
Practice question
for N
N
N
record the revaluation.

3.4 Depreciation of a revalued asset
After a non-current asset has been revalued, depreciation charges are based on
the new valuation.
Example:
An asset was purchased three years ago, at the beginning of Year1, for N100,000.
Its expected useful life was six years and its expected residual value was N10,000.
It has now been re-valued to N120,000. Its remaining useful life is now estimated to
be three years and its estimated residual value is now N15,000.
The straight-line method of depreciation is used.
Required
(a) What amount is recognised in other comprehensive income at the end of
Year 3?
(b) What is the annual depreciation charge in Year 4?
(c) What is the carrying amount of the asset at the end of Year 4?
N
Cost 100,000
Less: Accumulated depreciation at the time of
Revaluation (= 3years x N15,000) (45,000)
Carrying amount at the time of the revaluation 55,000
Revalued amount of the asset 120,000
Recognised in other comprehensive income
(and accumulated in are valuation surplus in 65,000
equity)
Revalued amount 120,000

Less: depreciation charge in Year 4 (35,000)
Carrying amount at the end of Year 4 85,000

Financial reporting
3.5 Realisation of the revaluation surplus

All assets eventually disappear from the statement of financial position either by
becoming fully depreciated or because the company sells them.
If nothing were done this would mean that there was a revaluation surplus on the
face of the statement of financial position that related to an asset that was no
longer owned.
IAS 16 allows (but does not require) the transfer of a revaluation surplus to
retained earnings when the asset to which it relates is derecognised (or realised).
This might happen over several years as the asset is depreciated or at a point in
time when the asset is sold.
Revalued assets being depreciated
Revaluation of an asset causes an increase in the annual depreciation charge.
The difference is known as excess depreciation (or incremental depreciation):
Excess depreciation is the difference between:
– the depreciation charge on the re-valued amount of the asset, and
– the depreciation that would have been charged on historical cost.
Each year a business might make a transfer from the revaluation surplus to the
retained profits equal to the amount of the excess depreciation.
Illustration:
Debit Credit
Revaluation surplus X
Retained earnings X
Revalued assets being sold

When a revalued asset is sold the business might transfer the balance on the
revaluation surplus in respect of the asset into retained earnings. The journal
entry would be the same as above.

Example:
for N
had an expected life of 10 years and nil residual value.
N N in
N
N
Double entry: Revaluation
Debit Credit
Asset (N640,000– N600,000) 40
Each year the business is allowed to make a transfer between the revaluation
surplus and retained profits:
Double entry: Transfer
Credit
Revaluation surplus (160/8)
Retained profits
3.6 Revaluation model: the frequency of revaluations

When the revaluation model is applied to the measurement of property, plant and
equipment, revaluations must be made with sufficient regularity to ensure that the
carrying amount does not differ materially from that which would be determined
using fair value at the end of the reporting period.
The frequency of revaluations should depend on the volatility in the value of the
assets concerned. When the value of assets is subject to significant changes
(high volatility), annual revaluations may be necessary.
However, such frequent revaluations are unnecessary for items subject to only
insignificant changes in fair value. In such cases it may be necessary to revalue
the item only every three or five years.

Financial reporting
4 DERECOGNITION OF PROPERTY, PLANT AND EQUIPMENT
Gain or loss on disposal of a non-currentasset

Accounting for the disposal of property, plant and equipment
Disposal of property, plant and equipment: part-exchange of an old asset
4.1 Gain or loss on disposal of a non-current asset

Property, plant and equipment are eventually disposed of:
– by sale, or
– if they have no sale value, through disposal as scrap.
Disposal can occur at any time and need not be at the end of the asset’s
expected useful life.
There is a gain or loss on disposal of the asset, as follows:
Illustration: Gain or loss on disposal
N
Sale proceeds on disposal X
Less disposal costs (X)
Net disposal value X
Asset at cost X
Less: accumulated depreciation (X)
Carrying amount at date of disposal (X)
Gain /loss on disposal X

Example:
A non-current as set originally cost N75,000. Accumulated depreciationis
N51,000.
The as set is now sold for N18,000. Disposal costs are N500.
What is the gain or loss on disposal?
Gain or loss on disposal N N

Sale proceeds on disposal 18,000
Less disposal costs (500)
Net disposal value 17,500
Asset at cost 75,000
Less: accumulated depreciation (51,000)
Carrying amount at date of disposal (24,000)
Loss on disposal (6,500)
Practice question
N
expected useful life was five years and its expected residual value was
N
for N
disposal costs.
It is the company policy to charge depreciation on a monthly basis.
The financial year runs from 1 January to 31 December.
What was the gain or loss on disposal?
Practice question
for N
N
for N
N
It is the company policy to charge a proportionate amount of depreciation
in the year of acquisition and in the year of disposal, in accordance with
the number of months for which the asset was held.
What was the gain or loss on disposal?

Financial reporting
4.2 Accounting for the disposal of property, plant and equipment

In the general ledger the gain or loss on disposal of a non-current asset is recorded
in a disposal of asset account. The double entry transactions required are as
follows – for an asset recorded at cost rather than at a re-valued amount.
Step 1: Transfer the cost of the non-current asset from the asset account to the
disposal account:
Step 2: Transfer the accumulated depreciation on the asset from the
accumulated depreciation account to the disposal account:
Credit
Disposal account
Non-current asset account (cost of the asset)
Accumulated depreciation account (or Allowance
for depreciation account)
Disposal account
The carrying amount of the asset is now in the disposal account.

Step 3: Record the disposal costs in the disposal account.
Credit
Disposal account (disposal expenses)
Bank or Payables account
Step 4: Record the sale proceeds in the disposal account:
Credit
Bank or Receivables account
Disposal account (sale proceeds)
Step 5: The balance on the disposal account is the gain or loss on disposal. This
is transferred to the statement of profit or loss.

Example:
A non-current asset cost N82,000 when purchased. It was sold for N53,000 when
the accumulated depreciation was N42,000. Disposal costs were N2,000.
Required
Show the book-keeping entries to record the disposal.
Answer
Disposal of asset account
N N
Non-current asset account 82,000 Accumulated depreciation 42,000
account
Disposal expenses (Bank) 2,000 Sales value (Receivables) 53,000
Gain on disposal 11,000
(statement of profit or loss)
95,000 95,000
Non-current asset account

N N
Opening balance 82,000 Disposal account 82,000
Accumulated depreciation account

N N
Disposalaccount 42,000 Openingbalance 42,000
Receivables account
N N
Disposal account
(sale valueofdisposal) 53,000
Bank account
N N
Disposal account
(disposal expenses) 2,000
Statement of profit or loss

N N
Disposal account
(gain on disposal) 11,000

Financial reporting
Non-current asset accounts in the general ledger are usually maintained for a
category of assets rather than for individual assets. This means that when a non-
current asset is disposed of, there will be a closing balance to carry forward on
the asset account and the accumulated depreciation account.
Example:
N mulated
N
The accounting entries would be as follows:
Property, plant and equipment account
N N
Opening balance b/f 500,000 Disposal account 82,000
Closing balance c/f 418,000
500,000 500,000
Opening balance b/f 418,000

N N
Disposal account 42,000 Opening balance b/f 180,000
Closing balance c/f 138,000
180,000 180,000
Opening balance b/f 138,000
Practice question
motor N the
reducing balance method at 25% each year. It has now been disposed for
N N
The balance on the motor vehicles account before the disposal was
N
N
Show the book-keeping entries to record the disposal.

4.3 Disposal of property, plant and equipment: part-exchange of an old

asset
Sometimes, a supplier will agree to take an old asset in part-exchange for the
sale of a new asset. This practice is quite common, for example, with motor
vehicles. A business entity may buy a new motor vehicle from a car dealer, and
the car dealer will take an old motor vehicle in part-exchange for the new one.
Disposals of assets in part-exchange for a new asset are accounted for in much
the same way as disposals of property, plant and equipment for cash. The only
difference is that:
‰ The disposal value of the old asset is the amount that the seller of the new
asset allows in part-exchange for the new asset.
‰ The cost of the new asset is the full purchase price, but the double entry is
partly to bank/payables (for the cash payment) and partly to the disposal
account for the old asset (for the part-exchange value).
Example:
Entity X has several motor cars that are accounted for as property, plant and
equipment.
As at 1January Year 5, the cost of the entity’s cars was N200,000 and the
accumulated depreciation was N80,000.
On 2 January Year 5, Entity X bought a new car costing N50,000.
The car dealer accepted a car owned by Entity X in part-exchange, and the
part- exchange value of this old car was N4,000.
This car originally cost N30,000 and its accumulated depreciation is N25,000.
Required
(a) Calculate the gain or loss on disposal of the old car.
(b) Show how the purchase of the new car and the disposal of the old car wil lbe
recorded in the ledger accounts of Entity X.
Answer
(a)
N N
Sale proceeds on disposal (part-exchange value) 4,000
Less disposal costs 0

Net disposal value 4,000
Less: Accumulated depreciation (25,000)

Financial reporting
Disposal of asset account

N N
Motor vehicles account 30,000 Accumulated 25,000
depreciation account
Motor vehicles
account
(Trade-in value) 4,000
Loss on disposal 1,000
(statement of profit
or loss)
30,000 30,000
Motor vehicles account

1 January N N
Bank (50,000 – 4,000) 46,000
Disposal of asset 4,000 Closing balance 220,000
account
250,000 250,000
2 January
Opening balance 220,000

1 January N N
Disposal account 25,000 Opening balance 80,000
Closing balance 55,000
80,000 80,000
2 January
N N
account (Cash
paid for new
car)
N N
Disposal account

Practice question
N
N
N
al N
part N
N
Required
Calculate the gain or loss on disposal of the old car.

Show how the purchase of the new car and the disposal of the old
car will be recorded in the ledger accounts.
5 DISCLOSURE REQUIREMENTS OF IAS 16
Disclosure requirements of IAS16

Accounting policies
5.1 Disclosure requirements of IAS16

IAS 16 requires the following disclosures in the notes to the financial statements,
for each major class of property, plant and equipment.
‰ The measurement bases used (cost or revaluation model);
‰ The depreciation methods used;
‰ The useful lives or depreciation rates used;
‰ Gross carrying amounts and the accumulated depreciation at the beginning
and at the end of the period;
‰ A reconciliation between the opening and closing values for gross carrying
amounts and accumulated depreciation, showing:
x Additions during the year;
x Disposals during the year;
x Depreciation charge for the year;
x Assets classified as held for sale in accordance with IFRS 5;
x Acquisitions of assets through business combinations;
x Impairment losses;
x The effect of revaluations.
The following is an example of how a simple table for tangible non-current assets
may be presented in a note to the financial statements.

Illustration:
Plant and
Property equipment Total
Cost Nm Nm Nm
At the start of the year 7,200 2,100 9,300
Additions 920 340 1,260
Disposals (260) (170) (430)
At the end of the year 7,860 2,270 10,130
Accumulated depreciation
At the start of the year 800 1,100 1,900
Depreciation expense 120 250 370
Accumulated depreciation on
disposals (55) (130) (185)
At the end of the year 865 1,220 2,085
Carrying amount
At the start of the year 6,400 1,000 7,400
At the end of the year 6,995 1,050 8,045

IAS 1 requires the disclosure of accounting policies used that are relevant to an
understanding of the financial statements. Property, plant and equipment often
includes the largest numbers in the statement of financial position and results in
significant expense in the statement of profit or loss.
One of the learning outcomes in this area is that you should be able to formulate
accounting policies for property, plant and equipment.

There are many aspects of accounting policy for property plant and equipment.
Below is a typical note which covers many of the possible areas.
Illustration: Accounting policy – Property, plant and equipment

Property, plant and equipment comprises freehold and leasehold land and
buildings, plant and machinery, fixture sand fittings, vehicles, office equipment
and capital work in progress.
Land and buildings
Land and buildings comprise mainly factories, warehousing and offices.
Freehold land and buildings are shown at their fair value less accumulated
depreciation. Valuations are performed with sufficient regularity to ensure that the
fair value of a revalued asset does not differ materially from its carrying amount.
Increases in the carrying amount arising on revaluation of land and buildings are
recognised in other comprehensive income and accumulated as a revaluation
surplus in equity.
Decreases that offset previous increases of the same asset are charged directly
to the revaluation surplus. Any amounts not so covered are recognized in profit or
loss for the period.
Depreciation is based on the carrying amount of the asset after the revaluation.
The incremental depreciation is the difference between the depreciation based on
historical cost and depreciation based on fair value. Each year this amount is
transferred from the revaluation surplus to accumulated profits.
Any accumulated depreciation at the date of revaluation is eliminated against the
gross carrying amount of the asset, and the net amount is restated to the revalued
amount of the asset.
When revalued assets are sold, the amounts included revaluation surplus in
respect of that asset is transferred to accumulated profits.
Freehold land has an indefinite useful life and is not depreciated. Freehold
buildings are depreciated on a straight-line basis over their useful economic lives
over as shown below.
Leasehold land and buildings are all depreciated on a straight-line basis over the
lease term.
Other tangible non-current assets
All other property, plant and equipment is carried at historical cost less
accumulated depreciation and accumulated impairment losses.
Historical cost includes expenditure that is directly attributable to the acquisition
of the items, the cost of replacing parts of the plant and equipment and borrowing
costs capitalised in accordance with IAS 23; Borrowing costs.

Illustration (continued): Accounting policy – Property, plant and equipment

Depreciation is calculated using the straight-line method to allocate their cost or
revalued amounts to their residual values over their estimated useful lives, as
follows:
Buildings 35-50 years
Machinery 5 to15 years
Vehicles 3 years
Furniture, fittings and equipment 5 to 10 years
The residual values and useful lives of assets are reviewed on an annual basis
and adjusted as appropriate.
Note from the above that there are two important areas where policies should be
explained to users of financial statements. These are:
– the depreciation policy; and
– the policy for subsequent measurement of property, plant and equipment.
Depreciation policy
The depreciable amount of an asset must be written off over its useful life.
Formulating a policy in this area involves:
– estimating the useful lives of different categories of assets;
– estimating residual values; and
– choosing a method.
Policy for subsequent measurement
Formulating a policy in this area involves:
– deciding whether to fair value any assets
– identifying classes of assets so that the policy can be applied to all assets
in that class;
– deciding on how to apply the IAS 16 guidance on frequency of revaluation;
and
– deciding how to change the carrying amount of the asset.
Illustration: Accounting policy

Property, plant and equipment, except freehold land, are stated at cost less
accumulated depreciation and any identified impairment loss.
Freehold land is stated at cost less any identified impairment loss.
Cost in relation to self-constructed assets includes direct cost of material, labour
and applicable manufacturing overheads and borrowing costs on qualifying asset.
Depreciation is charged to income, unless it is included in the carrying amount of
another asset, on straight line method whereby cost of an asset is written off over
Its estimated useful life at the rates given in note XX.
Residual value and the useful life of an asset are reviewed at least at each financial
year-end.
Depreciation on additions is charged from the month in which an asset is acquired,
while no depreciation is charged for the month in which the asset is disposed of.

Financial reporting
6 QUESTION PROBLEMS
Multiple assets
Correcting errors
6.1 Multiple assets

Exam questions on property, plant and equipment usually involve multiple assets
with the need to keep track of additions and disposals in a period.
In any one year the charge for depreciation will be made up as follows:
N
Depreciation of assets held for the whole year (these are
assets held at the start less disposals) X
Depreciation of assets sold in the year (up to the date of sale) X
Depreciation of assets bought in year (from the date of
purchase)
Depreciation charge for the year
It is often useful to construct a working to calculate the depreciation charge for

different components of the asset base.

Example: Depreciation of several assets (straight line)

A business has entered into the following transactions involving plant and
equipment over the last three years.
1 January 20 X 4 Bought several items of plant and equipment for
N
30 June 20 X 5 Bought several items of plant and equipment for
N
28 February 20 X 6 Bought several items of plant and equipment for
N
31 March 20 X 6 Sold some of the items which it had purchased
on
N
The company depreciates assets on a straight line basis at

10%per annum.
The depreciation in 20X4, 20X5 and 20X6 can be calculated as follows:
Depreciation:
20X4 20X5 20X6
N
In 20X6 this must be split:

50,000
500,000 u 10%
Assets sold: 7,500
N
20,000
Depreciation charge
127,500
Depreciation on the assets sold:

+ = N
Examples are more complicated when depreciation is calculated using the

reducing balance method.

Financial reporting
Example: Depreciation of several assets (reducing balance)

A business has entered into the following transactions involving plant and
equipment over the last three years.
1 January 20 X 4 Bought several items of plant and equipment for
N800,000.
30 June 20 X 5 Bought several items of plant and equipment for
N500,000.
28 February 20 X 6 Bought several items of plant and equipment for
N240,000.
31 March 20 X 6 Sold some of the items which it had purchased on
1 January 20 X 4. These items had cost N300,000.
The company depreciates assets using 20% reducing balance.

The depreciation in 20X4, 20X5 and 20X6 can be calculated as follows:
Depreciation:
20X4 20X5 20X6
20 X 4 purchase (N800,000)
800,000 u 20% 160,000
(800,000 – 160,000) u20% 128,000
In 20X6 the carrying amount of the
asset (800,000 – 160,000 -128,000
= 512,000) must be split:
Assets retained
(512,000u500/800): 320,000 u20% 64,000
Assets sold:(512,000u300/800):
192,000u20%u3/12 9,600
73,600
20 X 5 purchase (N500,000)
500,000 u20% u6/12 50,000
(500,000 – 50,000) u20% 90,000
20X6 purchase (N200,000)

240,000 u20% u10/12 40,000
Depreciation charge 160,000 178,000 203.600
Depreciation on the assets sold: N

300,000 u20% 60,000
(300,000 – 60,000) u20% 48,000
(300,000–60,000–48,000) u20%u3/12 9,600
117,600

6.2 Correcting errors

Questions might feature mistakes made in terms of a transaction incorrectly
classified as capital or as repair.
The balance on a business’s plant account as at 31 December is as

follows.
Cost 1,200,000
Accumulated depreciation (500,000)
Carrying amount 700,000
Depreciation is charged at 15% reducing balance.

Correction of the error:
The amount capitalised would have been depreciated so the
amount must be removed from cost and the depreciation incorrectly
charged must be removed.
The correcting journals are: Dr Cr
Statement of profit or loss:
line item to which repairs are charged 200,000
Plant – cost 200,000
and
(200,000 u15% u5/12) 12,500
The impact on the carrying amount of the plant is as follows:

N
Cost 1,200,000 (200,000) 1,000,000
Accumulated depreciation (500,000) 12,500 (487,500)
Carrying amount 700,000 512,500

Financial reporting
The balance on a business’s plant account as at 31 December is as

follows.
Cost 1,200,000
amount N
Depreciation is charged at 15% reducing balance.

Correction of the error:
The amount must be capitalised and depreciated.
The correcting journals are: Dr Cr
Plant – cost 200,000
line item to which repairs are charged 200,000

(200,000 u15% u5/12) 12,500
The impact on the carrying amount of the plant is as follows:

N
Cost 1,200,000 200,000 1,400,000
Accumulated depreciation (500,000) (12,500) (512,500)
Carrying amount 700,000 887,500
7 CHAPTER REVIEW
Measure property, plant and equipment on initial recognition
Measure property, plant and equipment after initial recognition using the cost
model and the revaluation model
Account for disposals of property plant and equipment
Construct basic notes to the financial statements in respect of property plant
and equipment

Financial reporting
SOLUTIONS TO PRACTICE QUESTIONS
Solution
= N
N
If the total useful life is anticipated to be7years then there are four
years remaining.
for = N = N
Solution 2
a Building account
N(000) N(000)
Balance b/d 1,000
Other comprehensive 2,000
income (N2m – N1m) 1,000 Balancec/d 2,000
2,000
Balance b/d
2,000
N(000) N(000)
Other comprehensive
income 60 Balance b/d 60
60 60

YEAR 1 N (000) N (000)
Building account 1.000
Balance c/d 1,060 Accumulated depreciation 60
1,060 1,060
Balance b/d 1,060
This balance would be transferred to a revaluation surplus account in equity.

Solution
= N =
N = N =
N N
Disposal value less disposal costs 68,000
Cost of the asset 96,000
Accumulated depreciation at the time of
disposal (27months u N1,333.33) (36,000)
Carrying amount at the date of disposal 60,000
Solutions
= N = N
N N
Disposal value 163,000
Less disposal costs (1,000)
162,000
Accumulated depreciation at the time of
disposal
Year to 31 December Year 1:(N24,000 u 7/12) 14,000
Years 2 and 3:(N24,000 u 2years) 48,000
Year to 31 December Year 4: (N24,000 u 8/12) 16,000
78,000
Carrying amount at the date of disposal 138,000

Financial reporting
Solution 5
N N
Year 1 depreciation (u25%) (20,000) 20,000
Carrying amount at end of Year 1 60,000
Year 2 depreciation (u25%) (15,000) 15,000
Accumulated depreciation at date of disposal 35,000
Disposal account
N N
Motor vehicles account 80,000 Accumulated depreciation 35,000
Bank (disposal costs) 200 Receivables 41,000
(loss on disposal) 4,200
80,200 80,200
Motor vehicles
N N
Opening balance b/d 720,000 Disposal of asset account 80,000
720,000 720,000
Accumulated depreciation on motor vehicles

N N
Disposal of asset
account 35,000 Opening balanceb/f 250,000
Closing balancec/d 215,000
250,000
Opening balanceb/d

N N

Less: Accumulated depreciation (18,000)
N N
Motor vehicles account account

Motor vehicles
account (Trade-in 8,000
value) 2,000
28,000
N N
Bank (31,000 – 8,000) 23,000
Disposal of asset
account 8,000 Closing balance 123,000
151,000 151,000
Accumulated depreciation on motor vehicles

N N
Disposal account 18,000 Opening balance 64,000
Closing balance 46,000
64,000 64,000

CHAPTER
Contents
IAS 23: Borrowing costs
IAS 20: Accounting for government grants and
disclosure of government assistance
IAS 40: Investment property
Chapter review

Financial reporting
INTRODUCTION
Aim
principles.
Detailed syllabus
statements
1 Tangible non-current assets
IAS 23, IAS 20 and IAS 40 are examinable documents
Exam context
This chapter explains further accounting rules on non-current assets.

„ Identify borrowing costs
„ Measure borrowing costs
„ Capitalise borrowing costs that relate to the production of qualify in gas sets
„ Account for government grants related to income
„ Account for government grants related to assets
„ Define investment property
„ Account for investent property using one of the two permitted methods

Chapter 8: Non-current assets: sundry standards
1 IAS 23: BORROWING COSTS
Introduction
Borrowing costs eligible for capitalisation
Period of capitalisation
1.1 Introduction
A company might incur significant interest costs if it has to raise a loan to finance
the purchase or construction of an asset. IAS 23: Borrowing costs defines
borrowing costs and sets guidance on the circumstances under which are to be
capitalised as part of the cost of qualifying assets.
Definition: Borrowing costs

Borrowing costs are interest and other costs that an entity incurs in connection
with the borrowing of funds.
Definition: Qualifying asset

A qualifying asset is an asset that necessarily takes a substantial period of time
to get ready for its intended use or sale.
Any of the following may be qualifying assets depending on circumstances:

▪ inventories;
▪ items of property, plant and equipment;
▪ intangible assets.
The following are not qualifying assets:

▪ inventories that are manufactured, or otherwise produced, over a short
period of time, are not qualifying assets
▪ assets that are ready for their intended use or sale when acquired.
Qualifying assets are usually self-constructed non-current assets.

Financial reporting
1.2 Borrowing costs eligible for capitalisation

Borrowing costs that are directly attributable to the acquisition, construction or
production of a qualifying asset must be capitalised as part of the cost of that asset.
All other borrowing costs are recognised as an expense in the period in which they
are incurred.
Borrowing costs that are directly attributable to the acquisition, construction or
production of a qualifying asset are those that would have been avoided if the
expenditure on the qualifying asset had not been made.
This includes the costs associated with specific loans taken to fund the production
or purchase of an asset and general borrowings. General borrowings are included
because if an asset were not being constructed it stands to reason that there would
have been a lower need for cash.
Funds specifically borrowed to obtain a qualifying asset

When a specific loan is taken in order to obtain a qualifying asset the borrowing
costs eligible for capitalisation are the actual borrowing costs incurred on that
borrowing during the period less any investment income on the temporary
investment of those borrowings.
N
a capital project which will take three years to complete.
Amounts not yet needed for the project are invested on a temporary basis.
N
the project.
N this
N amount
The amounts recognised as capital work in progress in the period was:

N
Costs incurred (labour, material, overhead etc.) 9,000,000
Interest capitalised:
Actual interest cost 1,250,000
Less: return on temporary investment (780,000)
470,000
Additions to capital work in progress 9,470,000
General funds used for the purpose of obtaining a qualifying asset.

When general borrowings are used the amount of borrowing costs eligible for
capitalisation is obtained by applying a capitalisation rate to the expenditures on that
asset.
The capitalisation rate is the weighted average of the borrowing costs applicable to
the borrowings that are outstanding during the period except for borrowings made
specifically for the purpose of obtaining a qualifying asset.
The amount of borrowing costs capitalised cannot exceed the amount of
borrowing costs it incurred during a period.

Shaki Construction has three sources of borrowing:

Average loan in the Interest expense incurred
year(N) in theyear(N)
7 year loan 8,000,000 800,000
10 year loan 10,000,000 900,000
Bank overdraft 5,000,000 900,000
The 7-year loan has been specifically raised to fund the building of a
qualifying asset.
A suitable capitalisation rate for other projects is found as follows:
Average loan in the Interest expense incurred
year(N) in the year (N)
10-year loan 10,000,000 900,000
Bank overdraft 5,000,000 900,000
15,000,000 1,800,000
Alternatively:
Weightedaverage:
6% + 6% = 12%

Financial reporting
The capitalisation rate is applied from the time expenditure on the asset is
incurred.
Example: General borrowings: Capitalisation rate

Continuing the example above, Shaki Construction has incurred the following
expenditure on a project funded from general borrowings for year ended 31
December 20X9.
N
31 March
st
1,000,000
31st July 1,200,000
30th October 800,000
The amount capitalised in respect of capital work in progress

during 20X9 is as follows:
N
31st March – Expenditure 1,000,000
Interest (1,000,000 u12% u9/12) 90,000
31st July –Expenditure 1,200,000

Interest (1,200,000 u12% u5/12) 60,000
30th October –Expenditure 800,000

Interest (800,000 u12% u2/12) 16,000
3,166,000
1.3 Period of capitalisation
Commencement of capitalisation
Capitalisation of borrowing costs should start only when:
▪ expenditures for the asset are being incurred; and
▪ borrowing costs are being incurred, and
▪ activities necessary to prepare the asset have started.
Suspension of capitalisation
Capitalisation of borrowing costs should be suspended if development of the
asset is suspended for an extended period of time.
Cessation of capitalisation
Capitalisation of borrowing costs should cease when the asset is substantially
complete. The costs that have already been capitalised remain as a part of the
asset’s cost, but no additional borrowing costs may be capitalised.

2 IAS 20: ACCOUNTING FOR GOVERNMENT GRANTS AND

DISCLOSURE OF GOVERNMENT ASSISTANCE
Introduction and definitions

Accounting treatment of government grants
Repayment of government grants
Disclosure requirements
2.1 Introduction and definitions

In many countries the government provides financial assistance to industry.
Definition: Government assistance

Government assistance is action by government designed to provide an economic
benefit specific to an entity or range of entities qualifying under certain criteria.
Government assistance takes many forms varying both in the nature of the
assistance given and in the conditions which are usually attached to it. The
purpose of the assistance may be to encourage an entity to embark on a course
of action which it would not normally have taken if the assistance was not
provided.
Government assistance does not include benefits provided only indirectly through
action affecting general trading conditions (e.g., provision of infrastructure in
development areas).
A common form of government assistance is a government grant.
Definition: Government grant

Government grants are assistance by government in the form of transfers of
resources to an entity in return for past or future compliance with certain conditions
relating to the operating activities of the entity.
They exclude those forms of government assistance which cannot reasonably
have a value placed upon them and transactions with government which cannot
be distinguished from the normal trading transactions of the entity.
A government grant may take a variety of forms, including:

‰ a receipt of cash;
‰ a reduction in aliability;
‰ the benefit of a low interest rate loan; or
‰ a forgivable loan from the government.
Definition: Forgivable loans

Forgivable loans are loans which the lender undertakes to waive repayment of
under certain prescribed conditions.
The form of the grant does not affect how it is accounted for.

Financial reporting
2.2 Accounting treatment of government grants

A grant must not be recognised until there is reasonable assurance that:
▪ the entity will comply with any conditions attaching to the grant; and
▪ the grant will be received.
Once these recognition criteria are met, the grants should be recognised in profit
or loss over the periods necessary to match them with their related costs.
IAS 20 defines the following two types of government grant based on the purpose
for which the grant is given:
▪ grants related to assets; and
▪ grants related to income.
Definition: Types of government grant

Grants related to assets: are government grants whose primary condition is that
an entity qualifying for them should purchase, construct or otherwise acquire long-
term assets. Subsidiary conditions may also be attached restricting the type or
location of the assets or the periods during which they are to be acquired or held.
Grants related to income are government grant sother than those related to
assets.
In most cases the periods over which the costs or expenses related to a
government grant are recognised are readily ascertainable.
▪ Grants in recognition of specific expenses are recognised in profit or loss in
the same period as the relevant expenses.
▪ Grants related to depreciable assets are usually recognised in profit or loss
over the periods and in the proportions in which depreciation expense on
those assets is recognised.
Both types of grant must be reported on a systematic basis through the
statement of profit or loss (profit or loss).
Grants related to income

For grants related to income, IAS 20 states that an ‘income approach’ should be
used, and the grant should be taken to income over the periods necessary to
match the grant with the costs that the grant is intended to compensate.
IAS 20 allows two methods of doing this:
‰ Method 1. Include the grant for the period as ‘other income’ for inclusion on
profit or loss for the period
‰ Method 2. Deduct the grant for the period from the related expense.

Example: Grant related to income

A company receives a cash grant of N30,000 on 31 December Year 0.
The grant is towards the cost of training young apprentices, and the training
programme is expected to last for 18 months from 1 January Year 1.
Actual costs of the training were N50,000 in Year 1 and N25,000 in Year 2.
The grant would be accounted for as follows:

At 31 December Year 0 the grant would be recognised as a liability and
presented in the statement of financial position split between current and non-
current amounts. N20,000 (12months/18months u N30,000) is current and would
be recognised in profit for Year1. The balance is non-current.
At the end of year 1 there would be a current balance of N10,000 (being the non-
current balance at the end of Year 0 reclassified as current) in the statement of
financial position. This would be recognized in profit in Year 2.
Extracts from the financial statements are as follows:
Statement of financial position (extracts)
31 December 31 December 31 December
Year 0 Year 1 Year 2
Current liabilities
Deferred income 20,000 10,000 –
Deferred income 10,000 – –
Statement of profit or loss (extracts)

31 December 31 December
Year 1 Year 2
Method 1
Training costs (50,000) (25,000)
Government grant received 20,000 10,000
Method 2
Training costs (50,000 – 20,000) 30,000
Training costs (25,000 – 10,000) 15,000
Grants related to assets

For grants related to assets, IAS 20 allows two methods of doing this:
‰ Method 1. Deduct the grant from the cost of the related asset. The asset is
included in the statement of financial position at cost minus the grant.
Depreciate the net amount over the useful life of the asset.
‰ Method 2. Treat the grant as deferred income and recognise it as income
on a systematic basis over the useful life of the asset.
These two methods achieve the same effective result.

Financial reporting
Example: Grant related to an asset

ant N
N
The asset has an estimated useful life of 10 years and no residual value.
The amounts could be reflected in the financial statements prepared at the end of
Year 1 in accordance with IAS 20 in the following ways:
Method 1:
Statement of financial position (extract)
Property, plant and equipment N
Cost (1,000,000 – 400,000) 600,000
Included in statement of profit or loss (extract) N

Depreciation charge(N600,000/10years) 60,000
Statement of financial position (extract)

Cost 1,000,000
Current liabilities
Deferred income 40,000
N
in in N N
Included in statement of profit or loss (extract) N

N (100,000)

Practice questions
On January Year 1 Entity O purchased a non-current asset with a cost of
N N in
The asset is being depreciated on a straight-line basis over five years.
Show how the asset and the grant would be reflected in the financial
statements at the end of the first year under both methods of accounting
for the grant allowed by IAS 20.
Grant received/receivable subject to conditions already met

A government grant may be awarded to in order to provide immediate financial
support rather than as incentive to undertake specific expenditures or as
compensation for expenses already incurred in a previous period.
In these cases, the double entry would be as follows:
Illustration: Double entry – grant with no conditions to meet

Debit Credit
Cash/receivable X
Statement of profit or loss X
2.3 Repayment of government grants

A government grant may become repayable. In this case it is accounted for as a
change in accounting estimate (IAS 8: Accounting policies, changes in
accounting estimates and errors).
A repayment of a grant related to income is first applied against any unamortised
deferred credit recognised in respect of the grant with any difference recognised
immediately in profit or loss.
A repayment of a grant related to an asset is accounted for as follows:
‰ If the grant has been recognised as a reduction of the cost of the asset the
repayment increases its carrying amount;
‰ If the grant has been recognised as deferred income the repayment
reduces the deferred income balance.
‰ In either case the extra depreciation that would have been recognised in
profit or loss to date in the absence of the grant is recognised immediately
in profit or loss.
Circumstances giving rise to repayment of a grant related to an asset might be an
indication of impairment of the asset. In this case the rules in IAS 36 Impairment
of assets apply.

Financial reporting
Example: Repayment of a grant related to an as set (deducted from the

cost of the asset)
A company received a government grant of N400,000 towards the cost of an
asset with a cost of N1,000,000.
The company deducted the grant from the cost of the asset.
Three years after the asset was purchased the company discovered an
irregularity in their original application for the grant. As a result of this the
company was required to repay the grant to the government.
Carrying amount of the asset before repayment:
Cost (1,000,000 – 400,000) 600,000
Accumulated depreciation (3 u 60,000) (180,000)
Double entry on repayment:

Dr Cr
Property, plant and equipment 400,000
Cash 400,000
The company has recognised a depreciation expense for this asset of

N180,000 over the last three years.
If the grant had not been received the company would have
recognised a depreciation expenseof N300,000 over this period.
This is N120,000 more than they have recognised due to the original accounting
for the grant.
Double entry to account for extra depreciation
Dr Cr
Profit or loss 120,000
Summary: carrying amount after the adjustment would be:

N
Carrying amount before adjustments 420,000
Repayment of grant 400,000
Adjustment to depreciation (120,000)
Carrying amount after the adjustment 700,000

Example: Repayment of a grant related to an asset (recognised as

deferred income)
A company received a government grant of N400,000 towards the cost of an
asset with a cost of N1,000,000.
The company recognised the grant as deferred income.
Three years after the asset was purchased the company discovered an
irregularity in their original application for the grant. As a result of this the
company was required to repay the grant to the government.
Carrying amounts of the asset and deferred income before repayment:
Carrying
Recognised amounts
over last 3 before
At start years repayment
Asset 1,000,000 (300,000) 700,000
Deferred income (400,000) 120,000 (280,000)
Net amount 600,000 (180,000) 420,000
Double entry on repayment:

Dr Cr
Cash 400,000
The company has recognised a net expense forth is asset of N180,000

over the last three years.
If the grant had not been received the company would have
recognized a depreciation expense of N300,000 over this period.
This is N120,000 more than they have recognized due to the original
accounting for the grant.
Double entry to account for extra depreciation
Dr Cr
Profitorloss 120,000
Summary: deferred income balance after the adjustment would be:

N
Carrying amount before adjustments (280,000)
Repayment of grant 400,000
Adjustment to depreciation (120,000)
Carrying amount after the adjustment nil

Financial reporting
Non-monetary government grants

A government grant may take the form of a transfer of a non-monetary asset
(e.g., airport landing rights, import quotas etc.).
In these cases both the grant and the asset can be measured either at:
‰ fair value; or
‰ a nominal amount.
2.4 Disclosure requirements

IAS 20 requires the following disclosures in the notes to the financial statements:
▪ the accounting policy adopted for government grants, including the method
of presentation in the financial statements
▪ the nature and extent of government grants recognised in the financial
statements and an indication of other forms of government assistance from
which the entity has directly benefitted
▪ unfulfilled conditions and other contingencies attaching to government
assistance (if this assistance has been recognised in the financial
statements).
Government assistance
The following forms of government assistance are excluded from the definition of
government grants:
▪ Assistance which cannot reasonably have a value placed upon them (e.g.,
free technical or marketing advice); and
▪ Transactions with government which cannot be distinguished from the
normal trading transactions (e.g., a government procurement policy that is
responsible for a portion of sales).
It might be necessary to disclose the nature, extent and duration of the
assistance in order that the financial statements may not be misleading when the
impact of the assistance is significant.

3 IAS 40: INVESTMENT PROPERTY
Definitions
Accounting treatment of investment property
Why investment properties are treated differently from other properties
Transfers and disposals of investment property
3.1 Definitions
IAS 40: Investment Property, defines and sets out the rules on accounting for
investment properties.
Definition
An investment property is property (land or a building, part of a building or both)
held to earn rentals or for capital appreciation or both.
Investment property differs from other property, which is:

▪ used in the production or supply of goods, or for administrative purposes; or
▪ held for sale in the ordinary course of business.
Investment property includes the building whilst it is under construction for
eventual use as an investment property.
The property could be owned or held under a lease.
The following are not investment property:
▪ property intended for sale in the ordinary course of business;
▪ property being constructed or developed on behalf of third parties; or
▪ owner-occupied property.

Financial reporting
3.2 Accounting treatment of investment property

The recognition criteria for investment property are the same as for property,
plant and equipment under IAS 16. An investment property should be recognised
as an asset only when:
▪ it is probable that future economic benefits associated with the property will
flow to the entity, and
▪ the cost of the property can be measured reliably.
Measurement at recognition
Investment property should be measured initially at cost plus the transaction
costs incurred to acquire the property.
Measurement after recognition

After initial recognition an entity may choose as its accounting policy:
▪ the fair value model, or
▪ the cost model.
The chosen policy must be applied to all the investment property of the entity.
Once a policy has been chosen it cannot be changed unless the change will
result in a more appropriate presentation. IAS 40 states that a change from the
fair value model to the cost model is unlikely to result in a more appropriate
presentation.
Fair value model for investment property

Under the fair value model the entity should:
▪ revalue all its investment property to ‘fair value’ (open market value) at the
end of each financial year, and
▪ recognise any resulting gain or loss in profit or loss for the period.
The property would not be depreciated.
This is different to the revaluation model of IAS 16, where gains are reported as
other comprehensive income and accumulated as a revaluation surplus.
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”.
If it is not possible to arrive at a reliable fair value figure then the cost model
should be adopted. This is an exception to the rule that all investment property
must be valued under either one model or the other.

Cost model for investment property

The cost model follows the provisions of IAS 16. The property is valued at cost
and the non-land element is depreciated.
Example: Accounting for investment property

On 1 January Year 1 Entity P purchased a building for its investment
potential. The building cost N1million with transaction costs of N10,000.
The depreciable amount of the building component of the property at this date
was N300,000.
The property has a useful life of 50 years.
At the end of Year 1 the property’s fair value had risen to N1.3 million.
The amounts which would be included in the financial statements of Entity P at

31 December Year 1, under the cost model are as follows:
Cost model
The property will be included in the statement of financial position as follows:
N
Cost (1,000,000 + 10,000) 1,010,000
Accumulated depreciation (300,000 ÷ 50 years) (6,000)
Carrying amount 1,004,000
The statement of profit or loss will include depreciation of N6,000.
The amounts which would be included in the financial statements of Entity P at

31 December Year 1, under the fair value model are as follows:
Fair value model
The property will be included in the statement of financial position at its fair
value of N1,300,000.
The statement of profit or loss will include again of N290,000 (N1,300,000 –
N1,010,000) inrespect of the fair value adjustment.

Financial reporting
3.3 Why investment properties are treated differently from other properties
Most properties are held to be used directly or indirectly in the entity’s business.
For example, a factory houses plant and equipment which is used to produce
goods for sale. The property is being consumed and it is appropriate to
depreciate it over its useful life.
An investment property also differs from other properties because it generates
revenue and cash flows largely independently of other assets held by an entity.
Furthermore, an investment property is held because it is expected to generate
wealth through rental income and capital appreciation. The fair value model is
based on the idea that that rental income and changes in fair value are
inextricably linked as integral components of the financial performance of an
investment property and measurement at fair value is necessary if that financial
performance is to be reported in a meaningful way.
The most relevant information about an investment property is its fair value (the
amount for which it could be sold). Depreciation is largely irrelevant. Therefore, it
is appropriate to re-measure an investment property to fair value each year and
to recognise gains and losses in profit or loss for the period.
IAS 40 allows a choice of accounting treatment for two reasons. Firstly, in order to
give preparers and users time to gain experience in using a fair value model and
secondly, to allow time for countries with less developed property market and
valuation professions to mature.
3.4 Transfers and disposals of investment property

If a property is transferred into or out of this category it must be reclassified as an
investment property or as no longer being an investment property. A transfer of
investment property can only be made where there is a change of use as illustrated
below. A change of use must be evidenced (e.g., commencement of owner
occupation) rather than merely be a change in management’s intention.
Circumstance Transfer to/from Deemed transfer value

Commencement Transfer from Fair value at the date of change of
of owner- investment use becomes the deemed cost for
occupation property to future accounting purposes
owner-occupied
property
End of owner- Transfer from Where investment properties are
occupation owner-occupied measured at fair value, revalue in
property to accordance with IAS 16 prior to the
investment transfer
property
Commencement Transfer from Fair value at the date of change of
of development investment use becomes the deemed cost for
with a view to property to future accounting purposes
sale inventories
Commencement Transfer from Fair value at the date of the transfer,
of a lease to inventories to and any difference compared to
another party investment previous carrying amount is
property recognised in profit or loss

Gain or loss on disposal
Gains or losses on disposals of investment properties are included in profit or

loss in the period in which the disposal occurs.
Example: Disposal of investment property

The investment property in the previous example was sold early in Year 2 for
N
N
Required
The amount that would be included in the statement of profit or loss for Year 2
in respect of this disposal under the cost modelis as follows:
Cost model N
Sale value 1,550,000
Selling costs (50,000)
Net disposal proceeds 1,500,000
Minus: Carrying amount (1,004,000)
The amount that would be included in the statement of profit or loss for Year 2
in respect of this disposal under the fair value model is as follows:
(Fair value model N
Sale value 1,550,000
Selling costs (50,000)
Net disposal proceeds 1,500,000
Minus: Carrying amount (1,300,000)

Financial reporting

The following disclosures are required by IAS 40 in the notes to the accounts.
Disclosure requirements applicable to both the fair value model and the cost
model
‰ whether the fair value model or the cost model is used
‰ the methods and assumptions applied in arriving at fair values
‰ the extent to which the fair value of investment property was based on a
valuation by a qualified, independent valuer with relevant, recent
experience
‰ amounts recognised in income or expense in the statement of profit or loss
for:
x rental income from investment property
x operating expenses in relation to investment property
‰ details of any restrictions on the ability to realise investment property or any
restrictions on the remittance of income or disposal proceeds
‰ the existence of any contractual obligation to purchase, construct or develop
investment property or for repairs, maintenance or enhancements.
Disclosure requirements applicable to the fair value model only

There must be a reconciliation, in a note to the financial statements, between
opening and closing values for investment property, showing:
▪ additions during the year
▪ assets classified as held for sale in accordance with IFRS5
▪ net gains or losses from fair value adjustments
▪ acquisitions through business combinations
This reconciliation should show separately any amounts in respect of investment
properties included at cost because their fair values cannot be estimated reliably.
For investment properties included at cost because fair values cannot be
estimated reliably, the following should also be disclosed:
▪ a description of the property
▪ an explanation as to why fair values cannot be determined reliably
▪ if possible, the range within which the property’s fair value is likely to lie.
Disclosure requirements applicable to the cost model only

– the depreciation methods used
– the useful lives or depreciation rates used
– gross carrying amounts and accumulated depreciation at the beginning and
at the end of the period

‰ A reconciliation between opening and closing values showing:

x additions
x depreciation
x assets classified as held for sale in accordance with IFRS5
x acquisitions through business combinations
x impairment losses
x transfers.
When the cost model is used, the fair value of investment property should also be
disclosed. If the fair value cannot be estimated reliably, the same additional
disclosures should be made as under the fair value model.

Financial reporting
4 CHAPTER REVIEW
Identify borrowing costs
Measure borrowing costs
Capitalise borrowing costs that relate to the production of qualifying assets
Account for government grants related to income
Account for government grants related to assets
Define investment property
Account for investment property using one of the two permitted methods

The amounts could be reflected in the financial statements prepared at the end of Year 1 in
accordance with IAS 20 in the following ways:
Method 1:
N
Cost (500,000 – 100,000) 400,000

Included instatement of profit or loss N
N
Method 2:
Property,plant and equipment N

Cost 500,000
Current liabilities
N in
in N N in the next
year and is therefore current. The balance is non-current.
Included in statement of profit or loss N

N (100,000)
N 20,000

9
Skills level
Financial Reporting
CHAPTER
IAS 38: Intangible assets
Contents
IAS 38: Intangible assets – Introduction
Internally generated intangible assets
Intangible assets acquired in a business combination
Measurement after initial recognition
Chapter review

Financial reporting
INTRODUCTION
Aim
principles.
Detailed syllabus
statements
2 Intangible non-current assets (IAS 38)
Calculate, where necessary, discuss and account for intangible non-current
assets in accordance with the provisions of IAS 38.
Exam context
This chapter explains the rules on accounting for intangible assets

„ Explain and apply the recognition rules to intangible assets acquired in different ways
„ Measure intangible assets on initial recognition
„ Measure intangible assets after initial recognition using the cost model and the
revaluation model

Chapter 9: IAS 38: Intangible assets
1 IAS38: INTANGIBLE ASSETS - INTRODUCTION
Introduction
Definition of an intangible asset
Recognition criteria for intangible assets
Separateacquisition
Exchange transactions
Granted by government
Subsequent expenditure on intangible assets
1.1 Introduction
IAS 38: Intangible assets sets out rules on the recognition, measurement and
disclosure of intangible assets.
IAS 38 establishes similar rules for intangible assets to those set out elsewhere
(mainly in IAS 16) for tangible assets. It was developed from the viewpoint that an
asset is an asset so there should be no real difference in how tangible and
intangible assets are accounted for. However, there is an acknowledgement that
it can be more difficult to identify the existence of an intangible asset so IAS 38
gives broader guidance on how to do this when an intangible asset is acquired
through a variety of means.
IAS 38:
‰ requires intangible assets to be recognised in the financial statements if,
and only if, specified criteria are met and explains how these are applied
however an intangible asset is acquired.
x A key issue with expenditure on ‘intangible items’ is whether it should
be treated as an expense and included in full in profit or loss for the
period in which incurred, or whether it should be capitalised and
treated as a long-term asset.
x IAS 38 sets out criteria to determine which of these treatments is
appropriate in given circumstances.
‰ explains how to measure the carrying amount of intangibles assets when
they are first recognised and how to measure them at subsequent reporting
dates;
x Most types of long-term intangible asset are ‘amortised’ over their
expected useful life. (Amortisation of intangible assets is the
equivalent of depreciation of tangible non-current assets.)
‰ sets out disclosure requirements for intangible assets in the financial
statements.

Financial reporting
1.2 Definition of an intangible asset
Definitions
An asset: A resource controlled by the company as a result of past events and from
which future economic benefits are expected to flow.
Intangible asset: An identifiable, non-monetary asset without physical substance’
An intangible asset is a type of asset. Therefore expenditure on an intangible

item must satisfy both definitions before it can be considered to be an asset.
Commentary on the definitions

Control
The existence of control is useful in deciding whether an intangible item meets
the criteria for treatment as an asset.
Control means that a company has the power to obtain the future economic
benefits flowing from the underlying resource and also can restrict the access of
others to those benefits.
Control would usually arise where there are legal rights, for example legal rights
over the use of patents or copyrights. Ownership of legal rights would indicate
control over them. However, legal enforceability is not a necessary condition for
control.
For tangible assets such as property, plant and equipment the asset physically
exists and the company controls it. However, in the case of an intangible asset,
control may be harder to achieve or prove.
Some companies have tried to capitalise intangibles such as the costs of staff
training or customer lists on the basis that they provide access to future
economic benefits. However, these would not be assets as they are not
controlled.
– Staff training: Staff training creates skills that could be seen as an asset for
the employer. However, staff could leave their employment at any time,
taking with them the skills they have acquired through training.
– Customer lists: Similarly, control is not achieved by the acquisition of a
customer list, since most customers have no obligation to make future
purchases. They could take their business elsewhere.
Future economic benefits

These may include revenues and/or cost savings.
Evidence of the probability that economic benefits will flow to the company may
come from:
– Market research;
– feasibility studies; and,
– a business plan showing the technical, financial and other resources
needed and how the company will obtain them.

Need to be identifiable
An intangible asset must also be ‘identifiable’. Intangibles, by their very nature,
do not physically exist. It is therefore important that this ‘identifiability test’ is
satisfied.
IAS 38 states that to be identifiable an intangible asset:
– must be separable ;or
– must arise from contractual or other legal rights.
To be separable, the intangible must be capable of being separated or divided
from the company, and sold, transferred, licensed, rented or exchanged.
Many typical intangibles such as patent rights, copyrights and purchased brands
would meet this test, (although they might fail other recognition criteria for an
intangible asset).
Without physical substance

Non-physical form increases the difficulty of identifying the asset.
Certain intangible assets may be contained in or upon an article which has
physical substance (e.g., floppy disc). Whether such assets are treated as
tangible or intangible requires. This judgement is based on which element is the
most significant.
‰ Computer software for a computer-controlled machine tool that cannot
operate without that specific software is an integral part of the related
hardware and it is treated as property, plant and equipment. The same
applies to the operating system of a computer.
‰ Computer software, other than the operating system, is an intangibleasset.
The same applies to licences, patents or motion picture films acquired or
internally generated by the reporting company.
Identifiable assets that result from research and development activities are
intangible assets because any physical element of those assets (for example, a
prototype) is secondary to the knowledge that is the primary outcome of those
activities.
1.3 Recognition criteria for intangible assets
Introduction
If an intangible item satisfies the definitions it is not necessarily recognised in the
financial statements. In order to be recognised it must satisfy the recognition
criteria for intangible assets.
If an item meets the definitions of being an asset, and being intangible, certain
recognition criteria must be applied to decide whether the item should be
recognised as an intangible asset.
Recognition
An intangible asset is recognised when it:
▪ complies with the definition of an intangible asset; and,
▪ meets the recognition criteria set out in the standard.

Recognition criteria
An intangible asset must be recognised if (and only if):
▪ it is probable that future economic benefits specifically attributable to the
asset will flow to the company; and,
▪ the cost of the asset can be measured reliably.
The probability of future economic benefits must be assessed using reasonable
and supportable assumptions that represent management’s best estimate of the
set of economic conditions that will exist over the useful life of the asset.
These recognition criteria are broadly the same as those specified in IAS 16 for
tangible non-current assets.
Measurement
An intangible asset must be measure at cost when first recognised.
Means of acquiring intangible assets

A company might obtain control over an intangible resource in a number of ways.
Intangible assets might be:
▪ purchased separately;
▪ acquired in exchange for another asset;
▪ given to a company by way of a government grant.
▪ internally generated;or
▪ acquired in a business combination;
IAS 38 provides extra guidance on how the recognition criteria are to be applied
and/or how the asset is to be measured in each circumstance.
1.4 Exchange transactions

1.5 Separate acquisition
Recognition guidance
The probability recognition criterion is always satisfied for separately acquired
intangible assets.
The price paid to acquire separately an intangible asset normally reflects
expectations about the probability that the future economic benefits embodied in
the asset will flow to the company. The effect of the probability is reflected in the
cost of theasset.
Also the c ost of a separately acquired intangible asset can usually be measured
reliably especially when the purchase consideration is in the form of cash or other
monetary assets.
Cost guidance
Cost is determined according to the same principles applied in accounting for
other assets.
The cost of a separately acquired intangible asset comprises:
‰ its purchase price, including any import duties and non-refundable
purchase taxes, after deducting any trade discounts and rebates; and
‰ any directly attributable expenditure on preparing the asset for its intended
use. For example:
x costs of employee benefits (as defined in IAS 19, Employee Benefits)
arising directly from bringing the asset to its working condition;
x professional fees for legal services; and
x costs of testing whether the asset is functioning properly.
The recognition of costs ceases when the intangible asset is in the condition
necessary for it to be capable of operating in the manner intended by
management.
Deferred payments are included at the cash price equivalent and the difference
between this amount and the payments made are treated as interest.
An intangible asset may be acquired in exchange or part exchange for another

intangible asset or another asset.
The cost of such items is measured at fair value unless:
– the exchange transaction lacks commercial substance; or,
– the fair value of neither the asset received nor the asset given up is reliably
measurable.
If the acquired item is not measured at fair value it is measured at the carrying
amount of the asset given up.
Note, that these rules are the same as those described for tangible assets in an
earlier chapter.
1.6 Granted by government

A government transfers or allocates intangible assets such as airport landing
rights, licences to operate radio or television stations, import licences or quotas
or rights to access other restricted resources.
An intangible asset may be acquired free of charge, or for nominal consideration,
by way of a government grant.
IAS 20: Accounting for Government Grants and Disclosure of Government
Assistance, allows the intangible asset and the grant to be recorded at fair value
initially or at a nominal amount plus any expenditure that is directly attributable to
preparing the asset for its intended use.
1.7 Subsequent expenditure on intangible assets

Subsequent expenditure is only capitalised if it can be measured and attributed to
an asset and enhances the value of the asset. This would rarely be the case:
▪ The nature of intangible assets is such that, in many cases, there are no
additions to such an asset or replacements of part of it.
▪ Most subsequent expenditure is likely to maintain the expected future
economic benefits embodied in an existing intangible asset rather than
meet the definition of an intangible asset and the recognition criteria.
▪ Also, it is often difficult to attribute subsequent expenditure directly to a
particular intangible asset rather than to the business as a whole.
Maintenance expenditure is expensed.

2 INTERNALLY GENERATED INTANGIBLE ASSETS
Internally generated intangible items

Research and development
Accounting treatment of development costs
2.1 Internally generated intangible tems

An internally generated intangible asset is an asset created by a company
through its own efforts. (An internally generated asset differs from an acquired
asset that has been purchased from an external seller.) For example, a
publishing company may build up legal copyrights by publishing books.
It can sometimes be difficult for a company to assess whether an internally-
generated asset qualifies for recognition as an asset in the financial statements
because:
– it is not identifiable; or
– its cost cannot be determinedreliably.
Recognition prohibited
IAS 38 prohibits the recognition of the following internally-generated intangible
items:
– goodwill;
– brands;
‰ mastheads (Note: a masthead is a recognisable title, usually in a distinctive
typographical form, appearing at the top of an item. An example is a
newspaper masthead on the front page of a daily newspaper);
– publishing titles;
– customer lists.
Recognition of these items as intangible assets when they are generated
internally is prohibited because the internal costs of producing these items cannot
be distinguished separately from the costs of developing and operating the
business as a whole.
Note that any of these items would be recognised if they were purchased
separately.
Goodwill
Most businesses have a value which is greater than the value of their net assets.
This is because there are other factors that contribute to the total value, for
example, the trading potential of a business.
Definition: Goodwill
Goodwill: An asset representing the future economic benefits arising from other
assets acquired in a business combination that are not individually identified and
separately recognised.

Financial reporting
In other words, the goodwill is an asset (insofar as it will generate future benefits)
that is unrecognised. It is measured as the difference of the value of a business
as a whole over the value of its net assets. As stated above, this is the case for
most businesses and it is described as internally generated goodwill. Internally
generated goodwill is not recognised as an asset.
When a company buys a controlling interest in another company, part of the
purchase consideration is to pay for the other company’s goodwill. This is
recognised as an asset in the group accounts of the company that has made the
purchase. This is not covered by this standard and is explained in more detail
later in chapters 19 and 20)
The value of a business as a whole might be less than the value of its net assets
but this is not discussed further at this point.
Other internally generated intangibles

IAS 38 provides further guidance on how to assess whether other internally
generated intangibles assets meet the criteria for recognition.
2.2 Research and development

The term ‘research and development’ is commonly used to describe work on the
innovation, design, development and testing of new products, processes and
systems.
Assessment of whether an internally generated intangible asset meets the criteria
for recognition requires a company to classify the generation of the asset into:
– a research phase; and
– a development phase.
If the research phase cannot be distinguished from the development phase the
expenditure on the project is all treated as that incurred on the research phase.
Research phase
Definition: Research
Research is original and planned investigation undertaken with the prospect of
gaining new scientific or technical knowledge and understanding.
Examples of research activities include:

▪ Activities aimed at obtaining new knowledge.
▪ The search for and evaluation of applications of knowledge obtained from
research.
▪ The search for alternative materials, products or processes.
▪ The formulation and testing of possible alternatives for new materials,
products or processes.
Research costs cannot be an intangible asset. Expenditure on research should
be recognised as an expense as it is incurred and included in profit or loss for the
period.

Development phase
Definition: Development
Development is the application of research findings or other knowledge to aplanor
design for the production of new or substantially improved materials, devices,
products, processes, systems or services before the start of commercial
production or use.
Examples of development activities include:

▪ The design, construction and testing of pre-production prototypes and
models.
▪ The design of tolls involving new technology.
▪ The construction and operation of a pilot plant that is not large enough for
economic commercial production.
▪ The design, construction and testing of new materials, products or
processes.
2.3 Accounting treatment of development costs

Development costs are capitalised when they meet certain further criteria. (These
comprise more detailed guidance on whether it is probable that future economic
benefits from the asset will flow to the entity and whether the cost can be measured
reliably).
Development costs must be recognised as an intangible asset, but only if all the
following conditions can be demonstrated.
▪ It is technically feasible to complete the development project.
▪ The company intends to complete the development of the asset and then
use or sell it.
▪ The asset that is being developed is capable of being used or sold.
▪ Future economic benefits can be generated. This might be proved by the
existence of a market for the asset’s output or the usefulness of the asset
within the company itself.
▪ Resources are available to complete the development project.
▪ The development expenditure can be measured reliably (for example, via
costing records).
If any one of these conditions is not met, the development expenditure must be
treated in the same way as research costs and recognised in full as an expense
when it is incurred.
Only expenditure incurred after all the conditions have been met can be
capitalised.
Once such expenditure has been written off as an expense, it cannot
subsequently be reinstated as an intangible asset.

Financial reporting
Example: Accounting treatment of development costs

Company Q has undertaken the development of a new product. Total costs to
date have been N800,000. All of the conditions for recognizing the development
costs as an intangible asset have now been met.
However, N200,000 of the N800,000 was spent before it became clear that the
project was technically feasible, could be resourced and the developed
product would be saleable and profitable.
Development costs.
The N200,000 incurred before all of the conditions for recognizing the
development costs as an intangible asset were met must be written off as an
expense.
The remaining N600,000 should be capitalised and recognized as an intangible
asset (development costs).
Initial measurement
The cost of an internally generated intangible asset is the sum of expenditure
incurred from the date when the intangible asset first meets the recognition
criteria for such assets.
Expenditure recognised as an expense in previous annual financial statements or
interim financial reports may not be capitalised.
The cost of an internally generated intangible asset comprises all expenditure
that can be directly attributed, and is necessary to creating, producing, and
preparing the asset for it to be capable of operating in the manner intended by
management.
Where applicable cost includes:
▪ expenditure on materials and services used or consumed;
▪ the salaries, wages and other employment related costs of personnel
directly engaged in generating the asset; and
▪ any expenditure that is directly attributable to generating the asset.
In addition, IAS 23 specifies criteria for the recognition of interest as an element
of the cost of an internally generated intangible asset. The IAS 23 guidance was
covered in the previous chapter.
Costs that are not components of cost of an internally generated intangible asset
include:
‰ selling and administration overhead costs;
‰ initial operating losses incurred;
‰ costs that have previously been expensed, (e.g., during a research phase)
must not be reinstated; and,
‰ training expenditure.

3 INTANGIBLE ASSETS ACQUIRED IN A BUSINESS COMBINATION
Recognition guidance
Cost guidance
In-process research and development
This section relates to intangible assets acquired when a company (the acquirer)
buys a controlling interest in another company (the acquiree). The section largely
relates to the recognition of intangibles in the consolidated financial statements of
the parent.
3.1 Recognition guidance

Any intangible asset identified in a business combination will be recognised as
both recognition criteria are deemed to be recognised.
The probability recognition criterion always considered to be satisfied for
intangible assets acquired in business combinations. This is because the fair
value of an intangible asset reflects expectations about the probability that the
expected future economic benefits embodied in the asset will flow to the
company. In other words, the entity expects there to be an inflow of economic
benefits.
The reliable measurement criterion is always considered to be satisfied for
intangible assets acquired in business combinations. If an asset acquired in a
business combination is separable or arises from contractual or other legal rights,
sufficient information exists to measure reliably the fair value of the asset.
Commentary
This means that an intangible asset that was not recognised in the financial
statements of the new subsidiary might be recognised in the consolidated
Illustration: Recognition
Company X buys 100% of Company Y.
CompanyY owns a famous brand that it launched several years ago.
Analysis
The brand is not recognized in Company Y’s financial statements (IAS 38 prohibits
the recognition of internally generated brands).
From the Company X group view point the brand is a purchased asset. Part of the
consideration paid by Company X to buy Company Y was to buy the brand and it
should be recognized in the consolidated financial statements.

Financial reporting
Examples of intangible assets

The following are all items that would meet the definition of an intangible asset if
acquired in a business combination.
‰ Market related intangibles
x Trademarks, trade names, service marks, collective marks and
certification marks;
x Internet domain names;
x Newspaper mastheads; and
x Non-competition agreements
‰ Customer related intangibles
x Customer lists;
x Order or production backlog;
x Customer contracts and the related customer relationships; and
‰ Artistic related intangibles
x Plays, operas and ballets;
x Books, magazines, newspapers and other literary works;
x Musical works (compositions, song lyrics and advertisingjingles);
x Pictures and photographs; and
x Video and audio visual material:
x Music videos; and
x Television programmes
‰ Contract based intangibles
x Licensing and royalty agreements;
x Construction permits;
x Franchise agreements
x Operating and broadcasting rights;
x Use rights such as drilling, water, air, mineral, timber-cutting and
route authorities;
‰ Technology based intangibles
x Patented and unpatented technology;
x Computer software and databases; and
x Trade secrets (secret formulas, processes, recipes)
3.2 Cost guidance

If an intangible asset is acquired in a business combination, its cost is the fair
value at the acquisition date.
If cost cannot be measured reliably then the asset will be subsumed within
goodwill.

3.3 In-process research and development

Another similar example involves in-process research and development
The acquiree might have a research and development project in process.
Furthermore, it might not recognise an asset for the project because the
recognition criteria for internally generated intangible assets have not been met.
However, the acquirer would recognise the in-process research and development
as an asset in the consolidated financial statements as long as it:
‰ meets the definition of an asset; and
‰ is identifiable, i.e., is separable or arises from contractual or other legal
rights.
Illustration: In-process research and development

Company X buys 100% of Company Y.
Company Y has spent N600,000 on a research and development project. This amount
as all been expensed as the IAS 38 criteria for capitalizing costs incurred in the
development phase of a project have not been met. Company Y has know how,
as the result of the project.
Company X estimates the fair value of Company Y’s know how which has arisen
as a result of this project to be N500,000.
Analysis
The in-process research and development is not recognised in Company Y’s
financial statements (IAS 38 prohibits the recognition of internally generated
brands).
From the Company X group view point the in-process research and development is
a purchased asset. Part of the consideration paid by Company X to buy Company
Y was to buy the know how resulting from the project and it should be recognised
in the consolidated financial statements at its fair value of N500,000.
Subsequent expenditure on an acquired in-process research and development

project
Expenditure incurred on an in-process research or development project acquired
separately or in a business combination and recognised as an intangible asset is
accounted for in the usual way by applying the IAS 38 recognition criteria.
This means that further expenditure on such a project would not be capitalised
unless the criteria for the recognition of internally generated intangible assets
were met.

Financial reporting
4 MEASUREMENT AFTER INITIAL RECOGNITION
Choice ofpolicy
Revaluation model
Amortisation of intangible assets
Disposals of intangible assets
4.1 Choice ofpolicy

Intangible assets are recognised at cost when first acquired.
IAS 38 allows a business to choose one of two measurement models as its
accounting policy for property, intangible assets after acquisition. The same
model should be applied to all assets in the same class.
The two measurement models for intangible assets after acquisition are:
▪ cost model (i.e. cost less accumulated depreciation); and
▪ revaluation model (i.e., revalued amount less accumulated depreciation
since the most recent revaluation).
Class of assets
The same model should be applied to all assets in the same class. A class of
intangible assets is a grouping of assets of a similar nature and use in an entity’s
operations. Examples of separate classes may include:
▪ brand names;
▪ mastheads and publishing titles;
▪ computer software;
▪ licences and franchises;
▪ copyrights, patents and other industrial property rights, service and
operating rights;
▪ recipes, formulae, models, designs and prototypes; and
‰ intangible assets under development.
Cost model
An intangible asset is carried at its cost less any accumulated amortisation and
any accumulated impairment losses after initial recognition.
4.2 Revaluation model
Intangible assets can be revalued according to the same rules as those applied
to the revaluation of property, plant and equipment. These were explained in
detail in the previous chapter so will be covered in less detail here.
An intangible asset is carried at a revalued amount, (its fair value at the date of
the revaluation less any subsequent accumulated amortisation and any
accumulated impairment losses).

This is only allowed if the fair value can be determined by reference to an active
market in that type of intangible asset.
Definition: Active market

An active market is a market in which all the following conditions exist:
(a) The items traded in the market are homogeneous;
(b) Willing buyers and sellers can normally be found at anytime; and
(c) prices are available to the public.
Active markets for intangible assets are rare. Very few companies revalue
intangible assets in practice.
The requirement that intangible assets can only be revalued with reference to an
active market is a key difference between the IAS 16 revaluation rules for
property, plant and equipment and the IAS 38 revaluation rules for intangible
assets.
An active market for an intangible asset might disappear. If the fair value of a
revalued intangible asset can no longer be measured by reference to an active
market the carrying amount of the asset going forward is its revalued amount at
the date of the last revaluation less any subsequent accumulated amortisation
and impairment losses.
Frequency of revaluations
Revaluations must be made with sufficient regularity so that the carrying amount
does not differ materially from its fair value at the reporting date.
The frequency of revaluations should depend on the volatility in the value of the
assets concerned. When the value of assets is subject to significant changes
(high volatility), annual revaluations may be necessary.
However, such frequent revaluations are unnecessary for items subject to only
insignificant changes in fair value. In such cases it may be necessary to revalue
the item only every three or five years.

Changing the carrying amount of the asset

When an item of property, plant and equipment is revalued, any accumulated
depreciation at the date of the revaluation is treated in one of the following ways:
Method 1: Restate accumulated depreciation proportionately with the change in
the gross carrying amount of the asset so that the carrying amount of the asset
after revaluation equals its revalued amount.
Method 2:
‰ Step 1: Transfer the accumulated depreciation to the asset account. The
result of this is that the balance on the asset account is now the carrying
amount of the asset and the accumulated depreciation account in respect
of this asset is zero.
‰ Step 2: Change the balance on the asset account to the revalued amount.
Accounting for the revaluation

The revaluation is carried out according to the same principles applied in
accounting for other assets.
IAS 38
Upwards Recognised in other comprehensive income and accumulated in
revaluations equity under the heading of revaluation surplus.
However: an increase is recognised in profit or loss to the extent that it

reverses a revaluation decrease of the same asset previously
recognised in profit or loss.
Downward Recognised in profit or loss.
revaluations
However: A decrease is recognised in other comprehensive income to the

extent of any credit balance in the revaluation surplus in respect
of that asset thus reducing the amount accumulated in equity
under the heading of revaluation surplus.
Realisation of the revaluation surplus

Most intangible assets eventually disappear from the statement of financial
position either by becoming fully amortised or because the company sells them.
If nothing were done this would mean that there was a revaluation surplus on the
face of the statement of financial position that related to an asset that was no
longer owned.
IAS 38 allows (but does not require) the transfer of a revaluation surplus to
retained earnings when the asset to which it relates is derecognised (realised).
This might happen over several years as the asset is depreciated or at a point in
time when the asset is sold.
Revaluation of an asset causes an increase in the annual depreciation charge.
The difference is known as excess depreciation (or incremental depreciation):
Excess depreciation is the difference between:
– the depreciation charge on the re-valued amount of the asset, and
– the depreciation that would have been charged on historicalcost.

Financial reporting
Each year a business might make a transfer from the revaluation surplus to the
retained profits equal to the amount of the excess depreciation.
4.3 Amortisation of intangible assets

A company must assess whether the useful life of an intangible asset is:
– finite: or
– indefinite.
If the useful life of an intangible asset is assessed as being finite the company
must assess its useful life.
An intangible asset is assessed as having an indefinite useful life when (based
on an analysis of all of the relevant factors) there is no foreseeable limit to the
period over which the asset is expected to generate net cash inflows.
Intangibles with a finite useful life

The depreciable amount of an intangible asset with a finite useful life is allocated
on a systematic basis over its useful life.
Amortisation begins when the asset is available for use, i.e., when it is in the
location and condition necessary for it to be capable of operating in the manner
intended by management.
Amortisation ends at the earlier of the date that the asset is classified as held for
sale in accordance with IFRS 5 and the date that the asset is derecognised.
The amortisation method used must reflect the pattern in which the asset's future
economic benefits are expected to be consumed by the entity. If that pattern
cannot be determined reliably, the straight-line method must be used.
The residual value of an intangible asset must be assumed to be zero unless:
‰ there is a commitment by a third party to purchase the asset at the end of
its useful life; or
‰ there is an active market for the assetand:
x residual value can be determined by reference to that market; and
x it is probable that such a market will exist at the end of the asset's
useful life.
The amortisation period and the amortisation method must be reviewed at least
at each financial year-end.
▪ Where there is a change in the useful life, the carrying amount (cost minus
accumulated depreciation) of the asset at the date of change is written off
over the (revised) remaining useful life of the asset.
▪ Where there is a change in the depreciation method used, this is a change
in accounting estimate. A change of accounting estimate is applied from the
time of the change and is not applied retrospectively. The carrying amount
(cost minus accumulated depreciation) of the asset at the date of the change
is written off over the remaining useful life of the asset.

Intangibles with an indefinite useful life

Where the useful life is assessed as indefinite:
– the intangible asset should not be amortised; but
– impairment reviews should be carried out annually (and even more
frequently if there are any indications of impairment).
The useful life of an intangible asset that is not being amortised must be reviewed
each period to determine whether events and circumstances continue to support
an indefinite useful life assessment for that asset.
If they do not, the change in the useful life assessment from indefinite to finite is
accounted for as a change in an accounting estimate in accordance with IAS 8.
This means that the carrying amount at the date of the change is amortised over
the estimated useful life from that date.
4.4 Disposals of intangible assets

The rules for de-recognition of intangible assets (accounting for their ‘disposal’)
are the same as for property, plant and equipment under IAS 16. There is a gain
or loss on disposal equal to the difference between the net disposal proceeds
and the carrying value of the asset at the time of disposal.
5 DISCLOSURE REQUIREMENTS
Accounting policies

In the financial statements, disclosures should be made separately for each class
of intangible asset. (Within each class, disclosures must also be made by
internally-generated intangibles and other intangibles, where both are recognised.)
Most of the disclosure requirements are the same as for tangible non-current
assets in IAS 16. The only additional disclosure requirements are set out below.
▪ Whether the useful lives of the assets are finite or indefinite.
▪ If the useful lives are finite, the useful lives or amortisation rates used.
▪ If the useful lives are indefinite, the carrying amount of the asset and the
reasons supporting the assessment that the asset has an indefinite useful
life.

1.2
Example:
An example is shown below of a note to the financial statement with disclosures
about intangible assets
Internally-
generated Software
development licences Goodwill Total
costs
N N N N
Cost
At the start of the year 290 64 900 1,254
Additions 60 14 - 74
Additions through business - - 20 20
combinations
Disposals (30)
–– (4)
–– ––- (34)
––––
At the end of the year 320
–– 74
–– 920
–– 1,314
––––
and impairment losses
At the start of the year 140 31 120 291
Amortisation expense 25 10 - 35
Impairment losses - - 15 15
Accumulated amortisation on 10 2 - 12
disposals
–– –– ––– –––
At the end of the year 175
–– 43
–– 135
––– 353
–––
Net carrying amount
At the start of the year 150 33 780 963
–– –– ––– –––
–– –– ––– –––
At the end of the year 145 31 785 961
‰ For any intangible asset that is individually material to the financial

statements, the following disclosure is required:
x a description
x its carrying amount
x the remaining amortisation period.
‰ The total amount of research and development expenditure written off (as
an expense) during the period must also be disclosed.
‰
IAS 1 requires the disclosure of accounting policies used that are relevant to an
understanding of the financial statements. Property, plant and equipment is often
includes the largest numbers in the statement of financial position and the results
in significant expense in the statement of profit or loss.
One of the learning outcomes in this area is that you be able to formulate
accounting policies for property, plant and equipment.
There are several areas that are important to explain to users of financial
statements.

Amortisation policy
The depreciable amount of an intangible asset must be written off over its useful
life.
Formulating a policy in this area involves estimating the useful lives of different
categories of intangible assets.
Under the guidance in IAS 38 the estimated residual values of an asset would
usually be zero and the straight line method would usually be used.
Other explanations:
This is not so much about choosing a policy as explaining situations to users:
– Development expenditure: Does the company haveany?
– Intangible assets acquired in business combinations in the period.
– Whether the company has intangible assets assessed as having an
indefinite useful llife.
Below is a typical note which covers many of the possible areas of accounting
policy for intangible assets.
Illustration: Accounting policy – Intangible assets

The intangible assets of the group comprise patents, licences and computer
software.
The group accounts for all intangible assets at historical cost less accumulated
amortisation and accumulated impairment losses.
Computer software
Development costs that are directly attributable to the design and testing of
identifiable and unique software products controlled by the group are recognised
as intangible assets when the following criteria are met:
a. it is technically feasible to complete the software product so that it will be
available for use;
b. management intends to complete the software product and use or sell it;
c. there is an ability to use or sell the software product;
d. it can be demonstrated how the software product will generate probable
future economic benefits;
e. adequate technical, financial and other resources to complete the
development and to use or sell the software product are available; and
f. the expenditure attributable to the software product during its development
can be reliably measured.
Directly attributable costs that are capitalised as part of the software product
include the software development employee costs and an appropriate portion of
relevant overheads.
Development expenditures that do not meet these criteria are recognised as an
expense as incurred. Costs associated with maintaining computer software
programmes are recognised as an expense as incurred.
Useful lives
Depreciation is calculated using the straight-line method to allocate their cost or
revalued amounts to their residual values over their estimated useful lives, as
follows:
Patents: 25 to 30 years
Licenses 5 to15 years
Computer software 3 years
All intangible assets are estimated as having a zero residual value.
6 CHAPTER REVIEW
Explain and apply the recognition rules to intangible assets acquired indifferent
ways
Measure intangible assets on initial recognition
Measure intangible assets after initial recognition using the cost model and the
revaluation model

CHAPTER
Contents
Impairment of assets
Cash generating units
Chapter review

Financial reporting
INTRODUCTION
Aim
principles.
Detailed syllabus
statements
3 Impairment of tangible and non-intangible assets (IAS 36)
Calculate, where necessary, discuss and account for impairment of tangible and
intangible non-current assets in accordance with the provisions of IAS 36.
Exam context
This chapter explains rules on impairment set out in IAS 36.

▪ Explain the objective of IAS 36
▪ Explain the IAS 36 impairment review process
▪ Estimate recoverable amount and hence impairment loss (if any)
▪ Account for impairment loss on assets carried under a cost model
▪ Account for impairment loss on revalued assets
▪ Define a cash generating unit
▪ Allocate impairment loss to assets within a cash generating unit

Chapter 10: IAS 36: Impairment of assets
1 IMPAIRMENT OF ASSETS
Objective and scope of IAS36

Identifying impairment or possible impairment
Measuring recoverable amount
Accounting for impairment
Summary of approach
1.1 Objective and scope of IAS 36

An asset is said to be impaired when its recoverable amount is less than its
carrying amount in the statement of financial position.
From time to time an asset may have a carrying value that is greater than its fair
value but this is not necessarily impairment as the situation might change in the
future. Impairment means that the asset has suffered a permanent loss in value.
The objective of IAS 36 Impairment of assets is to ensure that assets are
‘carried’ (valued) in the financial statements at no more than their recoverable
amount.
Scope of IAS 36
IAS 36 applies to all assets, with the following exceptions that are covered by
other accounting standards:
▪ inventories (IAS 2);
▪ construction contracts (IAS 11);
▪ deferred tax assets (IAS 12);
▪ financial assets (IAS 39);
▪ investment property held at fair value (IAS 40);
▪ non-current assets classified as held for sale (IFRS 5).
Recoverable amount of assets
Definition
The recoverable amount of an asset is defined as the higher of its fair value
minus costs of disposal, and its value in use.
Fair value is the price that would be received to sell an asset or paid to transfer
a liability in an orderly transaction between market participants at the
measurement date.
Value in use is the present value of future cash flows from using an asset,
including its eventual disposal.
Impairment loss is the amount by which the carrying amount of an asset (or a
cash-generating unit) exceeds its recoverable amount.
Cash-generating units will be explained later.

Financial reporting
Stages in accounting for an impairment loss

There are various stages in accounting for an impairment loss:
Stage 1: Establish whether there is an indication of impairment.
Stage 2: If so, assess the recoverable amount.
Stage 3: Write down the affected asset (by the amount of the impairment) to its
recoverable amount.
Each of these stages will be considered in turn.
1.2 Identifying impairment or possible impairment

An entity must carry out an impairment review when there is evidence or an
indication that impairment may have occurred. At the end of each reporting
period, an entity should assess whether there is any indication that impairment
might have occurred. If such an indication exists, the entity must estimate the
recoverable amount of the asset, in order to establish whether impairment has
occurred and if so, the amount of the impairment.
Indicators of impairment
The following are given by IAS 36 as possible indicators of impairment. These
may be indicators outside the entity itself (external indicators), such as market
factors and changes in the market. Alternatively, they may be internal indicators
relating to the actual condition of the asset or the conditions of the entity’s
business operations.
When assessing whether there is an indication of impairment, IAS 36 requires
that, as a minimum, the following sources are considered:
Externalsources Internal sources

An unexpected decline in the asset’s Evidence that the asset is damaged or
market value. no longer of use to the entity.
Significant changes in technology, There are plans to discontinue or
markets, economic factors or laws restructure the operation for which the
and regulations that have an adverse asset is currently used.
effect on the company.
An increase in interest rates, affecting There is a reduction in the asset’s
the value in use of the asset. expected remaining useful life.
The company’s net assets have a There is evidence that the entity’s
higher carrying value than the expected performance is worse than
company’s market capitalisation expected.
(which suggests that the assets are
over-valued in the statement of
financial position).
If there is an indication that an asset (or cash-generating unit) is impaired then it

is tested for impairment. This involves the calculating the recoverable amount of
the item in question and comparing this to its carrying amount.

Additional requirements for testing for impairment

The following assets must be reviewed for impairment at least annually, even
when there is no evidence of impairment:
– an intangible asset with an indefinite useful life; and
– goodwill acquired in a business combination.
1.3 Measuring recoverable amount

It has been explained that recoverable amount is the higher of an asset’s:
– fair value less costs of disposal; and
– its value inuse.
If either of these amounts is higher than the carrying value of the asset, there has
been no impairment.
IAS 36 sets out the requirements for measuring ‘fair value less costs of disposal’
and ‘value in use’.
Measuring fair value less costs of disposal

Fair value is normally market value. If no active market exists, it may be possible
to estimate the amount that the entity could obtain from the disposal.
Direct selling costs normally include legal costs, taxes and costs necessary to
bring the asset into a condition to be sold. However, redundancy and similar costs
(for example, where a business is reorganised following the disposal of an asset)
are not direct selling costs.
Calculating value in use

Value in use is a value that represents the present value of the expected future
cash flows from use of the asset, discounted at a suitable discount rate or cost of
capital. Value in use is therefore calculated by:
– estimating future cash flows from the use of the asset (including those from
ultimate disposal)
– discounting them to present value.
Estimates of future cash flows should be based on reasonable and supportable
assumptions that represent management’s best estimate of the economic
conditions that will exist over the remaining useful life of the asset.
The discount rate used should be the rate of return that the market would expect
from an equally risky investment.
However, both the expected future cash flows and the discount rate might be
adjusted to allow for uncertainty about the future – such as the business risk
associated with the asset and expectations of possible variations in the amount
or timing of expected future cash benefits from using the asset.

Financial reporting
Example: Measurement of recoverable amount

A company has a machine in its statement of financial position at a carrying
amount of N300,000.
The machine is used to manufacture the company’s best-selling product range,
but the entry of a new competitor to the market has severely affected sales.
As a result, the company believes that the future sales of the product over
the next three years will be only N150,000, N100,000 and N50,000. The asset
will then be sold for N25,000.
An offer has been received to buy the machine immediately for N240,000, but the
company would have to pay shipping costs of N5,000. The risk-free market rate
of interest is 10%.
Market changes indicate that the asset may be impaired and so the recoverable
amount for the asset must be calculated.
Fair value less costs of disposal N000
Fair value 240,000
Costs of disposal (5,000)
235,000
Year Cash flow(N000) Discount factor Present

value
1 150,000 1/1.1 136,364
2 100,000 1/1.12 82,645
3 50,000 + 25,000 1/1.13 56,349
275,358
The recoverable amount is the higher of N235,000 and N275,358, i.e.

N275,358.
The asset must be valued at the lower of carrying value and recoverable
amount.
The asset has a carrying value of N300,000, which is higher than the
recoverable amount from using the asset.
It must therefore be written down to the recoverable amount, and an
impairment of N24,642(N300,000 – N275,358) must be recognised.

1.4 Accounting for impairment

The impairment loss is normally recognised immediately in profit or loss.
amount
amount me must
This is accounted for as follows:
Debit Credit
Practice question
for
estimated useful life of 20 years and an estimated zero residual value.
Depreciation is on a straight-line basis.
On 1 January Year 4 an impairment review showed the machine’s
amount
years.
Calculate:
The carrying amount of the machine on 31 December Year 3
(immediately before the impairment).
The impairment loss recognised in the year to 31 December Year 4.
The depreciation charge in the year to 31 December Year 4.
However, an impairment loss recognised in respect of an asset carried at a

previously recognised revaluation surplus is recognised in other comprehensive
income to the extent that it is covered by that surplus. Thus, it is treated in the
same way as a downward revaluation, reducing the revaluation reserve balance
relating to that asset in the statement of changes in equity Impairment not
covered by a previously recognised surplus on the same asset is recognised in
profit or loss.

A company has a machine in its statement of financial position at a carrying
amount N3 N
amount N me must
N
This is accounted for as follows:
Debit Credit
Other comprehensive income 20,000
Following the recognition of the impairment, the future depreciation of the asset
must be based on the revised carrying amount, minus the residual value, over
the remaining useful life.
Practice question
for N
estimated useful life of 20 years and an estimated zero residual value.
Depreciation is on a straight-line basis.
N but
change in useful life at that date.
On 1 January Year 4 an impairment review showed the machine’s
amount N
years.
Calculate:
The carrying amount of the machine on 31 December Year 2 and
hence the revaluation surplus arising on 1 January Year 3.
The carrying amount of the machine on 31 December Year 3
(immediately before the impairment).
The impairment loss recognised in the year to 31 December Year 4.
The depreciation charge in the year to 31 December Year 4.

1.5 Summary of the approach

Impairment of an asset should be identified and accounted for as follows:
(1) At the end of each reporting period, the entity should assess whether there
are any indications that an asset may beimpaired.
(2) If there are such indications, the entity should estimate the asset’s
Recoverable amount.
(3) When the recoverable amount is less than the carrying value of the asset,
the entity should reduce the asset’s carrying value to its recoverable amount.
The amount by which the value of the asset is written down is an impairment
loss.
(4) This impairment loss is recognised as a loss for the period.
(5) However, if the impairment loss relates to an asset that has previously been
re-valued upwards, it is first offset against any remaining revaluation surplus
for that asset. When this happens, it is reported as other comprehensive
income for the period (a negative value) and not charged against profit.
(5) Depreciation charges for the impaired asset in future periods should be
adjusted to allocate the asset’s revised carrying amount, minus any residual
value, over its remaining useful life (revised if necessary).
2 CASH GENERATING UNITS
Cash-generatingunits
Allocating an impairment loss to the assets of a cash generating unit
Disclosure requirements for the impairment of assets
2.1 Cash-generating units

It is not always possible to calculate the recoverable amount of individual assets.
Value in use often has to be calculated for groups of assets, because assets may
not generate cash flows in isolation from each other. An asset that is potentially
impaired may be part of a larger group of assets which form a cash-generating
unit.
IAS 36 defines a cash-generating unit (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.
Goodwill
The existence of cash-generating units may be particularly relevant to goodwill
acquired in a business combination. Purchased goodwill must be reviewed for
impairment annually, and the value of goodwill cannot be estimated in isolation.
Often, goodwill relates to a whole business.
It may be possible to allocate purchased goodwill across several cash-generating
units. If allocation is not possible, the impairment review is carried out in two
stages:
1 Carry out an impairment review on each of the cash-generating units
(excluding the goodwill) and recognise any impairment losses that have
arisen.
2 Then carry out an impairment review for the entity as a whole, including the
goodwill.
2.2 Allocating an impairment loss to the assets of a cash generating unit

When an impairment loss arises on a cash-generating unit, the impairment loss is
allocated across the assets of the cash-generating unit in the following order:
▪ first, to the goodwill allocated to the cash-generating unit
▪ next, to the other assets in the cash-generating unit, on a pro-rata basis
(i.e. in proportion to the carrying amount of the assets of the cash-
generating unit).
However, the carrying amount of an asset cannot be reduced below the highest
of:
‰ its fair value less costs of disposal (ifdeterminable);
‰ its value in use (if determinable); and
‰ zero.

Example: Allocation of impairment loss in cash-generating unit

A cash-generating unit is made up of the following assets.
Nm
Property, plant and equipment 90
Goodwill 10
Other assets 60
160
The recoverable amount of the cash-generating unit has been assessed as
N140million.
The impairment loss would be allocated across the assets of the
cash-generating unit as follows:

There is a total impairment loss of N20million (=N160m – N140m).
Of this, N10million is allocated to goodwill, to write down the goodwill to
N0.The remaining N10million is then allocated to the other assets pro-rata.
Therefore:
N6million (=N10m × 90/150) of the impairment loss is allocated to
property, plant and equipment, and N4million = N10m×60/150) of
the loss is allocated to the other assets in the unit.
The allocation has the following result:
Before Impairment After
loss loss loss
Nm Nm Nm
Property, plant and equipment 90 (6) 84
Goodwill 10 (10) –
Other assets 60 (4) 56
160 (20) 140
2.3 Disclosure requirements for the impairment of assets

For all impairments, the following disclosures should be made for each class of
assets:
‰ The amount of impairment losses recognised in profit or loss for the period
and the line item in which those items are included.
‰ The amount of impairment losses on revalued assets that have been
recognised (or reversed) in other comprehensive income for the period
(and in the revaluation reserve).

Financial reporting
3 CHAPTER REVIEW
Explain the objective of IAS 36
Explain the IAS 36 impairment review process
Estimate recoverable amount and hence impairment loss (ifany)
Account for impairment loss on assets carried under a cost model
Account for impairment loss on revalued assets
Define a cash generating unit
Allocate impairment loss to assets within a cash generating unit


Solution
On 31 December Year 3 the machine was stated at the following amount
a) Carrying amount of the machine on 31 December Year
3 Cost
Accumulated depreciation (3 × (240,000 ÷ 20 years)) (36,000)
Carrying amount
Impairment
000).
in
depreciation charge is based on the recoverable amount of the asset.
Solution 2
a) Carrying amount on N
Cost 240,000
Accumulated depreciation at 1 January Year 3 (2 years ×
(240,000 ÷ 20)) (24,000)
Valuation at 1 January Year 3 250,000
Revaluation surplus 34,000
b) When the asset is revalued on 1 January Year 3, depreciation is charged on the

revalued amount over its remaining expected useful life.
On 31 December Year 3 the machine was therefore stated at:
Valuation at 1 January (re-valued amount) 250,000

Accumulated depreciation in Year 3 (= N250,000
÷18)) (13,889)
c) On 1 January Year 4 the impairment review shows an impairment loss of

N136,111(N236,111 – N100,000).
taken
(reducing the revaluation surplus for the asset to zero).
remaini

Contents CHAPTER
Sale of non-current assets
Classification of non-current assets (or
disposal groups) as held for sale
Measurement of non-current assets (or disposal
groups) classified as held for sale
Discontinued operations
Chapter review

Financial reporting
INTRODUCTION
Aim
Detailed syllabus
B
statements
1 Tangible non-current assets
IFRS 5 is an examinable document.
Exam context
This chapter explains the IFRS 5 rules on the measurement and presentation of non-current
assets held for sale and discontinued operations.

▪ Apply the held for sale criteria and identify if an assets is held for sale
▪ Measure assets classified as held for sale at the lower of carrying amount and fair
value less costs to sell
▪ Account for any loss arising on classification of an asset as held for sale
▪ Allocated any loss arising to assets within a disposal group classified as held for sale
▪ Explain and apply the presentation rules on assets held for sale
▪ Explain and apply the presentation rules on disposal groups held for sale
▪ Define and explain the accounting treatment for discontinued operations

Chapter 11: IFRS 5: Non-current assets held for sale and discontinued operations
1 SALE OF NON-CURRENT ASSETS

1.1 General rules on derecognition
When an asset is derecognised, its carrying amount is removed from the
statement of financial position. IAS 16 states that the carrying amount of an item
of property, plant and equipment should be derecognised in the following
circumstances:
– on disposal of the asset; or
– when no future economic benefits are expected to arise from its use or from
its disposal.
If a non-current asset is disposed of, the gain or loss on the disposal should be
included in profit or loss in the period in which the disposal occurs. The gain or
loss should not be included in sales revenue.
The gain or loss on the disposal is calculated as:
Illustration: Gain or loss on disposal
N
Sale proceeds on disposal
X
Less disposal costs (X)
Net disposal value X
Asset at cost/revalued amount X
Less: Accumulated depreciation (X)
Carrying amount at date of disposal (X)
Gain /loss on disposal X

Financial reporting
1.2 Assets that are held for sale

Sometimes, a company might hold an asset at the year-end that it has the
intention of selling.
IFRS 5 Non-current assets held for sale and discontinued operations
contain rules which impact the measurement and presentation of such assets.
In summary:
Non-current assets (and groups of non-current assets) that meet certain strict
criteria are classified as being held for sale.
Non-current assets that are held for sale are:
▪ subject to an impairment test;
▪ presented on a separate category on the face of the statement of financial
position; and
▪ are no longer depreciated.
Any loss recognised on a non-current asset carried at cost as a result of the
impairment test at the date of its classification as ‘held for sale’ is recognised in
the statement of profit or loss.
Any loss recognised on a non-current asset carried at a revalued amount as a
result of the impairment test at the date of its classification as ‘held for sale’ is
recognised in other comprehensive income (to the extent that it is covered by the
previously recognised surplus on the same asset) with the balance recognised in
The above rules will be explained in more detail in the following sections:
2 INTRODUCTION TO IFRS 5
Objective of IFRS 5
Scope of IFRS 5
2.1 Objective of IFRS 5

IFRS 5 sets out requirements that specify the accounting treatment for assets
held for sale, and the presentation and disclosure of discontinued operations.
IFRS 5 requires assets that meet the criteria to be classified as held for sale are:
▪ measured at the lower of carrying amount and fair value less costs to sell;
▪ not depreciated; and
▪ presented separately on the face of the statement of financialposition.
Additionally, the results of discontinued operations must be presented separately
in the statement of profit or loss.

IFRS 5 identifies three classes of item that might be described as held for sale.
These classes are of an increasing level of sophistication:
▪ non-current assets;
▪ disposal groups; and
▪ discontinued operations.
Disposal group
Definition
Disposal group–agroup of assets to be disposed of in as ingle transaction, and
any liabilities directly associated with those assets that will be transferred in the
transaction.
A disposal group may be a group of cash-generating units, a single cash-

generating unit, or part of a cash-generating unit.
Some disposal groups might fall into the definition of a discontinued operation.
2.2 Scope of IFRS 5
Classification and presentation

The classification and presentation requirements of IFRS 5 apply to all
recognised non-current assets and to all disposal groups.
Measurement
The measurement requirements of IFRS 5 apply to all recognised non-current
assets and disposal groups except for:
▪ deferred tax assets (IAS 12 Income Taxes).
▪ assets arising from employee benefits (IAS 19 Employee Benefits).
▪ financial assets within the scope of IAS 39 Financial Instruments:
Recognition and Measurement.
▪ non-current assets that are accounted for in accordance with the fair value
model in IAS 40 Investment Property.
▪ non-current assets that are measured at fair value less estimated point-of-
sale costs in accordance with IAS 41 Agriculture.
▪ contractual rights under insurance contracts as defined in IFRS 4 Insurance
Contracts.
Comment on the scope of IFRS 5

The scope of IFRS 5 is a little complicated.
A non-current asset that is scoped out of IFRS 5 for measurement purposes may
fall within the classification and presentation rules.
Such a non-current asset might be part of a disposal group. In this case the
measurement rules of IFRS 5 apply to the disposal group as a whole but not to
the scoped-out assets within the group which are measured individually
according to the rules set out in their own standards.

Abandonment of non-current assets
Non-current assets (or disposal groups) to be abandoned include non-current
assets (or disposal groups) that are to be:
– used to the end of their economic life; or
– closed rather than sold.
A non-current asset (or disposal group) that is to be abandoned must not be
classified as held for sale.
3 CLASSIFICATION OF NON-CURRENT ASSETS (OR DISPOSAL GROUPS)

AS HELD FOR SALE
Rule
Criteria
3.1 Rule
A non-current asset (or disposal group) must be classified as held for sale when
its carrying amount will be recovered principally through a sale transaction rather
than through continuing use.
3.2 Criteria
The following conditions must apply at the reporting date for an asset (or disposal
group) to be classified as held forsale:
‰ it must be available for immediate sale in its present condition subject only
to terms that are usual and customary for sales of such assets (or disposal
groups);
‰ the sale must be highly probable, i.e.:
x the appropriate level of management must be committed to a plan to
sell the asset (or disposal group);
x an active programme to locate a buyer and complete the plan must
have been initiated; and
x the asset (or disposal group) must be actively marketed for sale at a
price that is reasonable in relation to its current fair value;
‰ the sale must be expected to be completed within one year from the date of
classification (except in limited circumstances) and actions required to
complete the plan should indicate that it is unlikely that significant changes
to the plan will be made or that the plan will be withdrawn.
If the criteria are met for a non-current asset (or disposal group) after the
reporting date but before the authorisation of the financial statements for issue,
that asset must not be classified as held for sale as at the reporting date.
However, the entity is required to make certain disclosures in respect of the non-
current asset (or disposal group).

Financial reporting
Example: Classification of asset as held for sale

Entity had the following asset at 31 March Year 4.
A property that it offered for sale for N5million during June Year 3.
The market for this type of property has deteriorated and at 31 March Year 4 a
buyer had not yet been found.
Management does not wish to reduce the price because it hopes that the market
will improve.
Shortly after the year end (after 31 March Year 4) the entity received an offer of
N4million and the property was eventually sold for N3.5 million during May Year 4,
before the financial statements were authorised for issue.
Analysis as at 31 March Year 4

The property cannot be classified as ‘held for sale’.
A non-current asset qualifies as ‘held for sale’ if it is available for immediate sale
in its present condition and actively marketed for sale at a price that is reasonable
in relation to its current fair value.
The property had not been sold at the year-end although it had been on the market
for some time. It appears that the reason for this was that management were
asking too high a price; therefore, the price is not reasonable in relation to its
current fair value.
Example: Classification of asset as held for sale

Entity R had the following asset at 31 March Year 4.
Plant with a carrying value of N2.5 million.
At 31 March Year 4 the entity had ceased to use the plant but was still
Maintaining it in working condition so that it could still be used if needed.
Entity R sold the plant on 14 May Year 4.
Analysis as at 31 March Year 4
The plant cannot be classified as ‘held for sale’.
At the year-end management had not made affirm commitment to sell the plant.
Even though the plant was sold just after the year-end, IFRS 5 prohibits the
classification of non-current assets as ‘held for sale’ if the criteria are met after the
end of the reporting period and before the financial statements are signed.

4 MEASUREMENT OF NON-CURRENT ASSETS (OR DISPOSAL

GROUPS) CLASSIFIED AS HELD FOR SALE
Measurement of non-current assets and disposal groups held for sale

Allocation of an impairment loss on a disposal group
Subsequentre-measurement
Changes to a plan of sale
4.1 Measurement of non-current assets and disposal groups held for sale
Assets held for sale and disposal groups should be measured at the lower of:
▪ their carrying amount (i.e., current values in the statement of financial
position, as established in accordance with accounting standards and
principles), and
▪ fair value less costs to sell.
If the value of the ‘held for sale’ asset is adjusted from carrying amount to fair
value less costs to sell, any impairment should be recognised as a loss in the
statement of profit or loss for the period unless the asset to which it relates is
carried at a previously recognised revaluation surplus. In this case the loss is
taken to other comprehensive income to the extent that it is covered by the
previously recognised surplus on that asset. Any amount not covered is
recognised in the statement of profit or loss.
A non-current asset must not be depreciated (or amortised) while it is classified
as ‘held for sale’ or while it is part of a disposal group that is held for sale.
Example: Impact of classification as held for sale

An asset is reclassified as ‘held for sale’, when its carrying amount is N20 million.
Its fair value less estimated costs to sell is N17 million.
The asset should be revalued at N17million and a loss of N3 million should be
reported in the period.
If the carrying amount is less than the fair value less costs to sell there is no
impairment. In this case there is no adjustment to the carrying amount of the
asset. (A gain is not recognised on reclassification as held for sale).
Example: Impact of classification as held for sale

An asset is reclassified as ‘held for sale’, when its carrying amount is N20 million.
Its fair value less estimated costs to sell is N24 million.
The asset ‘held for sale’ should not be re-measured and should continue to be
carried at N20 million.
A gain on disposal will be included in profit for the period when the disposal
actually occurs.

Financial reporting
Practice question
for
life of 8 years and no residual value.
On 31 December Year 4 the machine was classified as held for sale. On
this air mated
for
Calculate the entries that are required in the statement of profit or loss for
Year 4 and Year 5.
Practice question
for
life of 8 years and no residual value.
On 31 December Year 4 the machine was classified as held for sale. On
this air mated
for
Calculate the entries that are required in the statement of profit or loss for
Year 4 and Year 5.

4.2 Allocation of an impairment loss on a disposal group

IFRS 5 requires that if an impairment loss is recognised for a disposal group, the
loss should be allocated to reduce the carrying amounts of those non-current
assets in the disposal group (that are within the scope of the IFRS 5 measurement
rules) in the following order:
‰ goodwill; then
‰ other non-current assets pro-rated on the basis of their carrying values.
An entity has decided to dispose of a group of its assets.

The carrying amount of the assets immediately before the classification as held to
sale were as follows:
Goodwill 20,000
Property, plant and equipment (at re-valued amounts) 52,000
Property, plant and equipment (at cost) 80,000
Inventory 21,000
Financial assets 17,000
Total 190,000
The entity estimates that the ‘fair value less costs to sell’ of the disposal group is
entity must
000)
Allocation of the impairment loss:
remaini
current assets in the disposal group prorat a to their carrying value.
Carrying Carrying
amount before Impairment amount
allocation loss after
allocation
N N N
Goodwill 20,000 20,000 –
Property, plant and
equipment (at re-valued
amounts) 52,000 3,939 48,061
Property, plant and
equipment (at cost) 80,000 6,061 73,939
Inventory 21,000 – 21,000
Financial assets 17,000 – 17,000
Total 190,000 30,000 160,000
pairment in

Financial reporting
4.3 Subsequent re-measurement

Subsequent re-measurement of the non-current asset (or disposal group) might
lead to:
▪ a further impairment loss - which must be recognised; or
▪ a gain, which is recognised but only to the extent that it is covered by a
previously recognised impairment loss.
4.4 Changes to a plan of sale

If an asset (or disposal group) has been classified as held for sale, but the criteria
are no longer met, it must be removed from this classification.
Such an asset is measured at the lower of:
▪ the amount at which it would have been carried if it had never been
classified as held for sale (i.e.: its carrying amount before it was classified
as held for sale as adjusted for any depreciation, amortisation or
revaluations that would have been recognised if it had not been so
classified); and
▪ its recoverable amount at the date of the subsequent decision not tosell.
Any necessary adjustment to the carrying amount is recognised in income from
continuing operations, in the same statement of profit or loss caption used to
present a gain or loss on assets held for sale.
5 PRESENTATION AND DISCLOSURE
„ Assets (or disposal groups) held forsale
5.1 Assets (or disposal groups) held for sale
Statement of financial position presentation

Non-current assets classified as held for sale are presented separately from
other assets in the statement of financial position.
The assets and liabilities of a disposal group classified as held for sale are
presented separately from other assets and liabilities in the statement of financial
position. These assets and liabilities must not be offset and presented as a single
amount.
The major classes of assets and liabilities classified as held for sale must be
separately disclosed either on the face of the statement of financial position or in
the notes.
This disclosure is not required for disposal groups that are newly acquired
subsidiaries that are classified as held for sale on acquisition.
Comparatives are not restated to reflect the classification in the statement of
financial position for the latest period presented.
Gains or losses
Any gain or loss on the re-measurement of a non-current asset (or disposal
group) classified as held for sale that does not meet the definition of a
discontinued operation is included in profit or loss from continuing operations.
The gain or loss recognised on measuring or re-measuring a non-current asset
(or disposal group) classified as held for sale is disclosed. If it is not presented
separately on the face of the statement of profit or loss, the caption that includes
that gain or loss must also be disclosed.
Other disclosures
The following information must be disclosed in the notes in the period in which a
non-current asset (or disposal group) has been either classified as held for sale
or sold:
‰ a description of the non-current asset (or disposal group);
‰ a description of the facts and circumstances of the sale, or leading to the
expected disposal, and the expected manner and timing of that disposal;
‰ if applicable, the segment in which the non-current asset (or disposal
group) is presented in accordance with IFRS 8 Operating segments.
6 DISCONTINUED OPERATIONS
Discontinued operation
Definition of discontinued operations
Presentation and disclosure of discontinued operations
6.1 Discontinued operation

IFRS 5 Non-current assets held for sale and discontinued operations sets
out requirements for disclosure of financial information relating to discontinued
operations.
The reason for requiring disclosure of information about discontinued operations
is as follows:
▪ closing down some operations will affect the future financial prospects of
the entity.
▪ it is therefore appropriate that users of the financial statements should be
provided with relevant information about the discontinuation. This will help
them to make a more reliable prediction of the future performance of the
entity.
This information can be produced by providing information about discontinued
operations separately from information about continuing operations.

6.2 Definition of discontinued operations
A discontinued operation is a disposal group that satisfies extra criteria. (IFRS 5
does not say as much but this is a helpful way to think of it).
Definition
Discontinued operation-Acomponent of an entity that either has been disposed
of or is classified as held for sale and:
1. represents a separate major line of business or geographical area of
operations,
2. is part of a single co-ordinated plan to dispose of a separate major line of
business or geographical area of operations or
3. is a subsidiary acquired exclusively with a view to resale.
A component of an entity comprises operations and cash flows that can be clearly
distinguished, operationally and for financial reporting purposes, from the rest of
the entity.
If an entity disposes of an individual non-current asset or plans to dispose of an
individual asset in the immediate future, this is not classified as a discontinued
operation unless the asset meets the definition of a ‘component of an entity’. The
asset disposal should simply be accounted for in the ‘normal’ way, with the gain
or loss on disposal included in the operating profit for the year.

An operation cannot be classified as discontinued in the statement of financial

position if the criteria for classifying it as discontinued are met after the end of the
reporting period.
For example, suppose that an entity with a financial year ending 30 June shuts
down a major line of business in July and puts another major line of business up
for sale. It cannot classify these as discontinued operations in the financial
statements of the year just ended in June, even though the financial statements
for this year have not yet been approved and issued.
A disposal group might be, for example, a major business division of a company.
For example a company that operates in both shipbuilding and travel and tourism
might decide to put its shipbuilding division up for sale. If the circumstances meet
the definition of ‘held for sale’ in IFRS 5, the shipbuilding division would be a
disposal group held for sale.
6.3 Presentation and disclosure of discontinued operations
Presentation in the statement of profit or loss

The following must be disclosed for discontinued operations:
‰ a single amount on the face of the statement of profit or loss comprising the
total of:
x the post-tax profit or loss of discontinued operations; and
x the post-tax gain or loss recognised on the measurement to fair value less
costs to sell or on the disposal of the assets or disposal group(s)
constituting the discontinued operation.
‰ an analysis of this single amount:
x the revenue, expenses and pre-tax profit or loss of discontinued
operations;
x the related income tax expense;
x the gain or loss recognised on the measurement to fair value less
costs to sell or on the disposal of the assets or disposal group(s)
constituting the discontinued operation; and
x the related income tax expense.
‰ the analysis may be presented in the notes or on the face of the statement
of profit or loss. (If presented on the face of the statement of profit or loss it
must be presented in a section identified as relating to discontinued
operations).
The analysis is not required for disposal groups that are newly acquired
‰ the net cash flows attributable to the operating, investing and financing
activities of discontinued operations.
These disclosures may be presented in the notes or on the face of the financial
statements.
These disclosures are not required for disposal groups that are newly acquired

Financial reporting
Comparatives
Comparatives must be restated for these disclosures so that the disclosures
relate to all operations that have been discontinued by the reporting date for the
latest period presented.
loss
Information relating to discontinued operations might be presented as
follows: Statement of profit or loss
20X9
20X9 20X8
N000 N000
Continuing operations
Revenue 9,000 8,500
Cost of sales (5,100) (4,700)
Gross profit 3,900 3,800
Other income 50 100
Distribution costs (1,200) (1,000)
Administrative expenses (1,400) (1,200)
Other expenses (150) (200)
Finance costs (300) (300)
Profit before tax 900 1,200
Income tax expense (300) (400)
Profit for the period from continuing operations 600 800
Discontinued operations
Profit for the period from discontinued operations 250 180
Profit for the period 850 980
Note
for

Presentation in the statement of financial position

Non-current assets classified as held for sale must be disclosed separately from
other assets in the statement of financial position.
Similarly, assets and liabilities that are part of a disposal group held for sale
must be disclosed separately from other assets and liabilities in the statement of
financial position.
This also applies to the assets and liabilities of a discontinued operation.
Example: Presentation of discontinued operations in the statement of

financial position
An entity has two disposal groups held for sale:
Disposal group
Group 1 Group 2 Total
N000 N000 N000
Property, plant and equipment 600 300 900
Liabilities (50) (20) (70)
Informatio nrelating to discontinued operations might be presented as follows:

N000
Assets

Currentassets 720
Non-current assets classified as held for sale (see above) 900
Total assets 3,620

Share capital 1,000
Reserves 1,950
Total equity 2,950
Non-current liabilities 400
Current liabilities 200
Liabilities directly associated with non-current assets
Classified as held for sale (see above) 70
Total liabilities 670
Note: In this summarised statement of financial position, the non-current assets
classified as ‘held for sale’ are the sum of the non-current assets of disposal
groups1and2(N600,000+ N300,000).
Similarly, the ‘liabilities directly associated with non-current assets classified as

held for sale’ are the sum of the liabilities for disposal groups 1 and 2.
In the statement of financial position, the comparative figures for the previous
year are not restated. The presentation in the statement of financial position
therefore differs from the presentation in the statement of profit or loss.

Financial reporting
7 CHAPTER REVIEW
Apply the held for sale criteria and identify if an assets is held for sale
Measure assets classified as held for sale at the lower of carrying amount and fair
value less costs to sell
Account for any loss arising on classification of an asset as held for sale
Allocated any loss arising to assets within a disposal group classified as held for
sale
Explain and apply the presentation rules on assets held for sale
Explain and apply the presentation rules on disposal groups held for sale
Define and explain the accounting treatment for discontinued operations

Solution
Year 4
The asset held for sales is carried at the lower
of: Carrying amount:
Cost
Depreciation up to the point of reclassification
80,000 u4 years/ 8 years (40,000)
Year 5
The asset is sold to give the following profit on disposal:
Proceeds 48,000
Carrying amount (40,000)
8,000

Financial reporting
Solution 2
Year 4
The asset held for sales is carried at the lower
of: Carrying amount: N
Cost 80,000
Depreciation up to the point of reclassification
80,000 u4 years/8 years (40,000)
40,000
Fair value less costs to sell (N41,000 – N2,000) 39,000
The machine is therefore written down to N39,000.
The statement of profit or loss for Year 4 will include an impairment loss of
39,000).
Year 5
The asset is sold to give the following loss on disposal:
N
Proceeds 37,500
Carrying amount (39,000)
1,500

CHAPTER
CHAPTER
Contents
Introduction and definitions
Lessee accounting
Chapter review

Financial reporting
INTRODUCTION
Aim
principles.
Exam context
This chapter explains the accounting treatment for leases from the point of view of the lessee
and the lessor.
This standard was published in 2016 as a replacement for IAS 17. It changes lessee
accounting but lessor accounting is the same as under the previous standard.
By the end of this chapter, you should be able to:

„ Prepare and present extracts of financial statements in respect of lessee accounting
1 INTRODUCTION AND DEFINITIONS

Section overview
„ Leases
„ Background to IFRS 16
„ Inception and commencement
„ Lease term
„ Lease payments
„ Residual values
„ Interest rate implicit in the lease
„ Initial direct costs
1.1 Leases
IFRS 16 prescribes the accounting treatment of leased assets in the financial
statements of lessees and lessors.
Definition: Lease
Lease: A contract, or part of a contract, that conveys the right to use an asset (the
underlying asset) for a period of time in exchange for consideration.
A lease is a way of obtaining a use of an asset, such as a machine, without

purchasing it outright. The company that owns the asset (the lessor) allows
another party (the lessee) to use the asset for a specified period of time in return
for a series of rental payments.
1.2 Background to IFRS 16
Leases give lessees the right to use assets in return for the lessees accepting an
obligation to make a series of payments to the owner of the asset, the lessor.
The previous accounting rules set out in IAS 17: Leases focused on identifying
leases that were economically similar to purchasing the asset being leased.
When this was the case, the lease was classified as a finance lease and reported
on the lessee’s statement of financial position. All other leases were classified as
operating leases and were not reported on the lessee’s statement of financial
position.
The problem
Operating leases gave lessees the right to use assets and impose obligations on
the lessee to pay fort his right in the same way as finance leases. The rights and
obligations under operating leases often satisfied the definitions of assets and
liabilities set out in the conceptual framework yet these were not recognised on
the statement of financial position. Consequently, a lessee’s statement of financial
position provided a misleading picture about leverage and the assets that the
lessee uses in its operations.
The 2013 World Leasing Yearbook reported that new leases entered into world
wide in 2011 amounted to almost N800 billion but under the previous rules the
majority of those leases were not reported on a lessee’s statement of financial
position.
Illustration:
The US Securities and Exchange Commission (SEC) estimated that US public
companies had approximately N1.25 trillion of off-balance-sheet undiscounted
operating lease commitments in 2005
Conclusion
The distinction between operating and financial leases is arbitrary and
unsatisfactory. IAS 17 did not provide for the recognition in lessees’ balance
sheets of material assets and liabilities arising from operating leases.
Comparability (and hence usefulness) of financial statements will be enhanced
by replacing the old treatment with an approach that applied the same
requirements to all leases. IFRS 16 removes the finance lease, operating lease
distinction for lessees. The new rules require a lessee to recognise all leases on
its statement of financial position (with certain exceptions).
IFRS 16 does not change how lessors should account for leases. Lessors still
must classify leases as either finance leases or operating leases and account for
them accordingly in the same way as before.
1.3 Inception and commencement
Definitions: Inception date of the lease

The earlier of the date of a lease agreement and the date of commitment by the
parties to the principal terms and conditions of the lease.

This is where the parties to the lease contract commit to the terms of the contract.
▪ Contracts must be assessed at the inception date to find out if they are a
lease or if they contain a lease.
▪ A lessor must identify the type of lease in a contract (finance or operating)
at the date of inception.
Definition: Commencement date of a lease

The date on which a lessor makes an underlying asset available for use by a
lessee.
This is the date that a lessee starts to use the asset or, at least, is entitled to start
to use the asset.
The accounting treatment required is applied to a lease at the commencement
date.
1.4 Lease term

IFRS 16 refers to different periods when describing its rules.
Definition: Lease term

The non-cancellable period for which a lessee has the right to use an underlying
asset, together with both:
(a) Periods covered by an option to extend the lease if the lessee is
reasonably certain to exercise that option; and
(b) periods covered by an option to terminate the lease if the lessee is
reasonably certain not to exercise that option.
A lease may be split into a primary period followed by an option to extend the
lease for a further period (a secondary period).
In some cases, the lessee might be able to exercise such an option with a small
rental or even for no rental at all. If such an option exists and it is reasonably
certain that the lessee will exercise the option, the second period is part of the
lease term.
A lease may allow a lessee to terminate the lease before its end. The period
covered by the termination option is included in lease term if it is reasonably
certain that the lessee will not exercise that option.
Example: Lease term

X plc signed a contract for the lease of an asset
Terms include:
Non-cancellable term = 5years at an annual rental of N100,000
Option to extend for a further 5 years at an annual rental of N1
Analysis
X plc is likely to exercise the option
Lease term = 10 years

Example: Lease term
X plc signed a contract for the lease of an asset
Terms include:
Non-cancellable term = 5years at an annual rental of N100,000 Option
to extend for a further 5 years at an annual rental of N200,000
Analysis
X plc is unlikely to exercise the option
Lease term = 5 years
1.5 Lease payments

In essence, the term lease payments refers to the payments that a lessee
expects to make over a lease term or to the receipts that a lessor expects over
the economic life of the asset.
In a straight forward example the lease payments that a lessee expects to make
and a lessor expects to receive are same. However, this is not always the case.
The definition of lease payments takes that into account.
Definition: Lease payments

Payments made by a lessee to a lessor relating to the right to use an underlying
asset during the lease term, comprising the following:
(a) fixed payments (including in-substance fixed payments), less any lease
incentives;
(b) variable lease payments that depend on an in dexora rate;
(c) the exercise price of a purchase option if the lessee is reasonably certain
to exercise that option; and
(d) payments of penalties for terminating the lease, if the lease term reflects
the lessee exercising an option to terminate the lease.
For the lessee, lease payments also include amounts expected to be payable by
the lessee under residual value guarantees. Lease payments do not include
payments allocated to non-lease components of a contract, unless the lessee
elects to combine non-lease components with a lease component and to account
for them as a single lease component.
For the lessor, lease payments also include any residual value guarantees
provided to the less or by the lessee, a party related to the lessee or a third party
unrelated to the lessor that is financially capable of discharging the obligations
under the guarantee. Lease payments do not include payments allocated to non-
lease components.
Lease payments as defined are included in the accounting treatment for leases
described later in this chapter.
Variable lease payments that do not depend on an index or a rate are not lease
payments as defined. For example, a lease term that required the payment of a
percentage of lessee’s sales revenue to the lessor is not a lease payment. Such
amounts would be recognised in profit or loss and would be part of lease
accounting.

Chapter 12: IFRS 16: Leases
1.6 Residual values

When a company that owns an asset leases it to another party they have two
interests in that asset:
– It gives them a right to receive a series of rentals over the lease term; and
– They own the asset at the end of the lease.
The value of the asset at the end of the lease is called its residual value. This
figure might be guaranteed by the lessee. This means that if the asset is not
worth the amount guaranteed, the lessee must pay the lessor the short fall.
On the other hand the residual value might not be guaranteed.
Definition: Residual value guarantee and unguaranteed residual value

Residual value guarantee: A guarantee made to a less or by a party unrelated
to the lessor that the value (or part of the value) of an underlying asset at the end
of a lease will be atleast a specified amount.
Unguaranteed residual value: That portion of the residual value of the
underlying asset, the realization of which by a less or is not assured or is
guaranteed solely by a party related to the lessor.
The guaranteed and unguaranteed residual values might influence the lessor’s
classification of a lease and therefore how it is accounted for.
1.7 Interest rate implicit in the lease
Definition: Interest rate implicit in the lease

Interest rate implicit in the lease: The rate of interest that causes:
(a) the present value of the lease payments and the unguaranteed residual
value; toequal
(b) the sum of the fair value of the underlying asset and any initial direct
costs of the lessor.
The interest rate implicit in the lease is the IRR of the cash flows from the lessor’s
viewpoint. It is the rate that equates the future cash inflows for the lessor to the
amount that the lessor invested in the asset.

Financial reporting
Y Plc leases an asset to X plc.
must al in
X Plc must also guarantee the residual value of the asset at the end of the lease
The interest rate implicit in the lease is calculated as follows:
Discount Present Discount Present

factor at value at factor at value at
Year Cashflow 7% 7% 9% 9%
0 (426,494) 1.000 (426,494) 1,000 (426,494)
1–5 100,000 4.100 410,000 3.890 389,000
5 40,000 0.713 28,520 0.650 26,000
NPV 12,026 (11,494)
NPV୅
AΨ
ͳǤͲʹΨ
It is unlikely that you will have to calculate the interest rate implicit in the lease in
an exam question. The working has been provided here to illustrate the definition.
The impact of rentals paid in advance on the interest rate implicit in the lease
If two leases are identical except that the rentals are in arrears for one (as above)
and in advance for the other, the interest rates implicit in each will be different.
The lease for which the payments are in advance will be higher than the lease for
which the payments are in arrears. This is because, although the total cash flows
to and from the lessor will be the same, if payment is in advance they will be
received by the lessor (paid by the lessee) over a shorter period. Thus, although
the total interest is the same it is recognised more quickly in the lease for which
the payments are in advance.

Example: Interest rate in herent in the

lease Y Plc leases an asset to X plc.
The asset cost Y Plc N426,494.
X Plc must pay five annual rentals of N100,000 inadvance.
term to be N40,000.
The interest rate implicit in the lease is calculated as follows:
Discount Present Discount Present
factor at value at factor at value at
Year Cashflow 10% 10% 13% 13%
0 (426,494) 1.000 (426,494) 1,000 (426,494)
0 100,000 1.000 100,000 1,000 100,000
1–4 100,000 3.170 317,000 2.974 297,400
4 40,000 0.683 27,320 0.613 24,520
NPV 17,826 (4,574)
Using IRRൌ AΨ୅൬ NPV୅ ൰ൈ ሺB AሻΨ

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NPV୅ൌ NPV
୅ͳ୅ǡͺʹ୅
IRRൌ ͳͲΨ୅൬ ൰ൈ ሺͳ͵ൌ ͳͲሻΨ
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IRRൌ ͳʹ
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1.8 Initial direct costs

The definition of interest rate implicit in the lease makes reference to incremental
initial direct costs.
Definition: Initial direct costs

Incremental costs of obtaining a lease that would not have been incurred if the
lease had not been obtained, except for such costs incurred by a manufacturer or
dealer less or inconnection with a finance lease.
Both the lessor and the lessee might incur initial direct costs. The calculation of
the interest rate implicit in the lease is from the lessor’s viewpoint. Therefore,
the initial direct costs that feature in this calculation are those of the lessor.
The accounting treatment for initial direct costs will be explained later.

Financial reporting
2 LESSEE ACCOUNTING
Initialrecognition
Subsequent measurement of the asset
Subsequent measurement of the liability
Allocating the finance charge(interest)
Current and non-current elements of the lease liability
Lease payments made in advance
Other issues
Presentation
Disclosure
2.1 Initial recognition

A lease is capitalised at the commencement of the lease term. This involves the
recognition of the asset that is subject to the lease (the underlying asset or right-
of-use asset) and a liability for the future lease payments.
The initial double entry is based on the lease liability but the asset might also
contain other components in its initial measurement.
Illustration: Double entry (in part) on initial recognition of a lease

Debit Credit
Asset X
Lease liability X
Initial measurement of the lease liability

The lease liability is measured at the commencement date as the present value
of the lease payments not yet paid at that date.
The lease payments are discounted using the interest rate implicit in the lease or,
if that rate cannot be readily determined, the lessee’s incremental borrowing rate
is used.
Definition: Lessee’s incremental borrowing rate

Lessee’s incremental borrowing rate: The rate of interest that a lessee would
have to pay to borrow over a similar term, and with a similar security, the funds
necessary to obtain an asset of a similar value to the right-of-use asset in a similar
economic environment.
The liability is the capital amount (the principal) that the lessee will have to pay
back to the lessor over the term of the lease. It is the present value of the
lessee’s lease payments.

Example: Initial measurement of a lease liability

X plc enters intoa lease. The following information is relevant:
must al in
The
interest rate implicit in the lease is 8%.
Discount Present
factor at valueat
Year Cash flow 8% 8%
1–5 100,000 3.993 399,271
5 40,000 0.683 27,223
426,494
The amount paid before the commencement date and the initial direct costs
are not included in the measurement of the liability.
Initial measurement of the right-of-use asset

The right-of-use asset is measured at the commencement date as follows:
Initial measurement of the lease liability

Lease payments made at or before the commencement date
(less lease incentives received)
Initial direct costs incurred (by the lessee)
Estimate of the costs of dismantling and removing the asset
and restoring the site where it is located (when the entity has
an obligation to dismantle and remove the asset at the end of
its life)

Financial reporting
Example: Initial measurement of a lease

X plc enters into alease. The following information is relevant:
must al in
The
interest rate implicit in the lease is 8%.
The double entries to account for this lease are as follows:
Dr Cr
On initial recognition
Right-of-use asset 426,494
Lease liability 426,494
Right-of-use asset N 5,000

Cash 5,000
The right-of-use asset is measured as follows on initial

recognition:
N
Initial measurement of the lease liability 426,494
Initial direct costs (lessee’s) 5,000
431,494
2.2 Subsequent measurement of the asset

After the commencement date, a right-of-use asset is measured using a cost
model unless it is a type of asset for which an alternative measurement model is
being used.
▪ If a lessee uses the IAS 40: Investment property fair value model for its
investment properties, that model must be used for right-of-use assets that
meet the definition of investment property; and
▪ If a lessee applies the revaluation model in IAS 16: Property, plant and
equipment to a class of property, plant and equipment it may elect to apply
the same accounting treatment to all right-of-use assets that relate to that
class.

Cost model
The cost model is used in the usual way by applying the depreciation
requirements in IAS 16: Property, plant and equipment.
The asset is measured as follows using the cost model
Non-current asset at cost N

Less a ccumulated depreciation and accumulated
impairment loss
Adjustments arising on remeasurement of the lease
liability (see later)
Carrying amount X
An asset is depreciated from the commencement date to the end of its useful life
when:
▪ the lease transfers ownership of the underlying asset to the lessee by the
end of the lease term; or
▪ if the cost of the right-of-use asset reflects that the lessee will exercise a
purchase option.
In other cases the asset is depreciated from the commencement date to the
earlier of:
▪ the end of its useful life; or
▪ the end of the lease term
Example: Subsequent measurement of the asset

X Plc enters into a 5 year lease of a machine on 1 January Year 1.
N
N
X Plc has guaranteed the residual value of the asset at the end of the leasetermat
N
The estimated useful life of the asset is 5 years.
The accounting policy for similar owned machines is to depreciate the mover
their useful life on a straight-line basis.
Annual depreciation charge:
Initial cost: N
Lease liability on initial measurement 426,494
Initial direct costs 5,000
431,494
Residual value (40,000)
Depreciable amount 391,494
Useful life (shorter of the lease term and the useful life) 5 years
Annual depreciation charge 78,299

Financial reporting
The rules in IAS 36: Impairment of assets apply to right-of-use assets in the usual
way.
The leased asset is included in the statement of financial position at its carrying
amount (cost less accumulated depreciation) in the same way as similar assets.
2.3 Subsequent measurement of the liability
During each year, the lessee makes one or more lease payments. The payment
is recorded in the ledger account as follows.
Credit
Leaseliability
Cash/bank
A lease liability is measured as follows at each reporting date:
Amount borrowed at the start of the lease (the

amount recognized on initial recognition of the lease)
Plus: Interest accrued
Repayment
of loan principal
Adjustment on remeasurement of the liability (see later)
Amount owed now.
In effect, each lease payment consists of two elements:

‰ a finance charge (interest charge) on the liability; and
‰ a partial repayment of theliability.
The finance charge is treated as a finance cost in profit or loss for the period. The
partial repayment of the lease obligation reduces the amount of the liability that
remains unpaid.

Finance charge
The total rental payments over the life of the lease will be more than the amount
initially recognised as a liability. The difference is finance charge.
The total finance charge that arises over the life term is the difference between
the amount initially recognised as the lease liability and the sum of the lease
payments from the standpoint of the lessee.
N
Lessee’s lease payments (total) X
Amount on initial recognition
Total finance charge
Example: Total finance charge

The lease liability at the commencement of the lease was N426,494 and X Plc incurred
initial direct costs of N5,000 when arranging the lease.
X Plc has guaranteed the residual value of the asset at the end of the lease term at
N40,000.
Total finance charge
Lessee’s lease payments:
Annual rentals (5u100,000) 500,000
Guaranteed residual value 40,000
540,000
Amount o ninitial recognition (426,494)*
Total finance charge (interest) 113,506
*This is the amount of the liability, The asset is recognised at N431,494.
The finance charge (interest) is recognised over the life of the lease by adding a
periodic charge to the lease liability with the other side of the entry as an expense
in profit or loss for the year.
Illustration:
Debit Credit
Statement of profit or loss: interest X
expense Lease liability X

Financial reporting
2.4 Allocating the finance charge (interest)

The total finance charge for a leased asset is allocated “so as to provide a
constant rate of charge on the outstanding obligation”.
This means that as the lease liability decreases at each year-end, the interest
charge for the next year will be lower than it was for the previous year.
The periodic rate of interest is the discount rate used in the initial measurement
of the lease liability. Using an interest rate to allocate the interest expense is
called an actuarial method. (The sum of digits method usually gives an
acceptable approximation to the actuarial method).
Actuarial method
Discounting arithmetic is used to calculate the interest rate implicit in the lease
and this is used to discount the lease payments to arrive at the lease liability at
initial recognition. If the interest rate that is implicit in the lease is not
determinable the lessee’s incremental borrowing rate is used.
This interest rate used is then applied to the opening balance of the lease liability
at the start of each period, in order to calculate the finance charge.
Example: Allocation of the finance charge

N
N
X Plc has guaranteed the residual value of the asset at the end of the
leasetermat N
The interest rate implicit in the lease is 8%.
Lease liability:
Opening Lease Closing
Year liability Interest (8%) payments liability
1 426,494 34,120 (100,000) 360,614
2 360,614 28,849 (100,000) 289,463
3 289,463 23,157 (100,000) 212,620
4 212,620 17,010 (100,000) 129,630
5 129,630 10,370 (140,000) 0
113,506
The interest expense is calculated by multiplying the opening liability by 8%

in each year (so as to provide a constant rate of charge on the outstanding
obligation).

The lease liability consists of the capital balance outstanding. This can be shown
as follows:
Example: Lease liability:

Opening Lease Interest Capital Closing
Year balance payments (8%) repayments balance
1 426,494 (100,000) 34,120 (65,880) 360,614
2 360,614 (100,000) 28,849 (71,151) 289,463
3 289,463 (100,000) 23,157 (76,843) 212,620
4 212,620 (100,000) 17,010 (82,990) 129,630
5 129,630 (140,000) 10,370 (89,630) 0
The final payment

In the above example the final payment by the lessee is N140,000.This is infact
madeupoftwoamounts,the final rental of N100,000 and the guaranteed residual
value of N40,000.
It is worth considering the payment in respect of the guaranteed residual value in
a little more detail.
At the end of the lease the asset that is the subject of the lease is transferred
back to the lessor. It has been depreciated down to Its estimated residual
value of N40,000.
The transfer is recorded as follows:
Example: Final payment in respect of the guaranteed residual value

Debit Credit
Right-of-use asset 40,000
In other words the N40,000 part of the finaly e arpayment to the lessor of
N140,000 is not cash but the transfer of the asset.
If the asset is worth less than N40,000 the lessee must make good any short fall.
In this case the asset is written down to its value at the date of the transfer
(as agreed between the lessee and the lessor) and the lessee will pay cash
to the lessor to compensate for any difference.

Financial reporting
amount N but
N
The lessee would make the following double entries.
Write down the asset
Asset under lease
Lease liability
Asset held under lease
Cash/bank
2.5 Current and non-current elements of the lease liability

The total liability must be divided between:
‰ the current liability (amount payable within the next 12 months), and
‰ the non-current liability.
The easy way to do it is to use the tables to identify the current liability or the
non-current liability and then find the other as a balancing figure.
Example: Split of current and non-current

liabilityattheendofyear1
Opening Lease Capital Closing
Year balance payments Interest repayments balance
1 426,494 (100,000) 34,120 (65,880) 360,614
2 360,614 (100,000) 28,849 (71,151) 289,463
n n
This is the This is the
current non-current
liability liability
Liability: N
Current liability 71,151
Non-current liability 289,463
Total liability (for proof) 360,614

2.6 Lease payments made inadvance

An earlier section explained that if two leases are identical except that the rentals
are in arrears for one and in advance for the other, the interest rates implicit in
each will be higher for the lease for which the payments are in advance. This is
because although the total lease payments are the same, if payment is in
advance they will be received by the lessor (paid by the lessee) over a shorter
period.
The overall result should be that the initial right-of-use asset and the total finance
charge is the same.
Example: Initial measurement of a lease (payments in advance)

X plc enters into a lease. The following information is
relevant: must al N
in
X Plc must also guarantee the residual value of the asset at the end of the
lease t N
N
The interest rate implicit in the lease is 12.37%.
Discount Present
factor at value at
Year Cash flow 12.37% 12.37%
1–4 100,000 3.014 301,404
4 40,000 0.627 25,090
326,494
Double entry on initial recognition Dr Cr

Right-of-use asset (as before in section 2.3) 431,494
Cash (first rental) 100,000
Cash (initial direct costs) 5,000
Payments in Payments in
Finance charge advance arrears (see
Lessee’s lease payments: N section 2.3)
N
Annual rentals (4 u100,000) 400,000
Annual rentals (5 u100,000) 500,000
Guaranteed residual value 40,000 40,000
440,000 540,000
Amount on initial recognition (326,494) (426,494)
Total finance charge (interest) 113,506 113,506

Financial reporting
When the lease payments are made at the start of each period instead of the end
of the period and payments are discounted using the interest rate implicit in the
lease, the total finance charge is the same but the interest rate used is different.
(This is not the case if the lease payments are discounted using the lessee’s
incremental borrowing rate but this will be explained later).
The finance charge allocation is as follows:
Liability
Opening Lease after day 1 Interest Closing
Year liability payment payment (12.37%) liability
1 326,494 – 326,494 40,387 366,881
2 366,881 (100,000) 266,881 33,013 299,895
3 299,895 (100,000) 199,895 24,727 224,621
4 224,621 (100,000) 124,621 15,379 140,000
5 140,000 (140,000) 0 0
In the above example, the lease payments are made at the start of each year.
The first lease payment has not been included in the initial measurement of the
lease liability so there is lease payment shown in year 1.
The lease payment shown in year 2 is on the first day of that year. Therefore, it is
deducted from the liability to give an amount upon which interest is charged
goingforward.
Current and non-current liability

If payments are made annually in advance, then ext payment is a
currentliability. Therefore, in the above example the N100,000
paidon1JanuaryYear2isa current liability and the balance N266,881) is an
on-current liability.
Liability
1 326,494 – 326,494 40,387 366,881
2 366,881 (100,000) 266,881
ȸ ȸ ȸ
Total
Total liability
liability
liability
N
Current liability
Totalliability(forproof)

The closing liability at the end of year 1 is made up of the interest accrued in year
1 and the capital outstanding which will be paid off in later years. The payment
made one day later (at the start of the next year) therefore pays the year 1
interest (N40,387) and the balance (N59,613) reduces the capital outstanding.
These elements could be shown separately with the closing liability at the end of
year 1 as identified on the previous page (N366,881) being made up of three
parts:
‰ The interest recognised in year1 but unpaid at the year-end (N40,387);
‰ The current element of the capital owed on the lease (N59,613); and
‰ the non-current element of the capital owed on the lease (N266,881).
Liability
1 326,494 – 326,494 40,387 366,881
2 366,881 (100,000) 266,881
ȸ ȸ ȸ
Total
Non-current liability
Total liability
liability due to
liability
interest
Liability: N
Current liabilities
Interest expense 40,387
Capital element of lease liability 59,613
100,000
Non-current liability 266,881
Total liability (for proof) 366,881
The fair value of an asset, leased under al ease commencing on1 January Year1
is N
for N
Year 2 and Year 3.
The interest rate implicit in the lease is 22.25%.
Required
Complete the lease payment table for all three years 1 to 3, and calculate the
current liability and the non-current liability at 31 December Year 1 under the
actuarial method.

Financial reporting
Impact of using the lessee’s incremental borrowing rate

The above section illustrated that the initial right-of-use asset and the total finance
charge is the same for two leases whose only difference is that payments are made
in advance for one and in arrears for the other provided the interest rate implicit in
the lease is used to measure the leaseliability.
This is not the case if the lessee’s incremental borrowing rate is used (because the
interest rate implicit in the lease is not readily determinable). This is because the
same discount rate would be used for payments in advance and for payments in
arrears.
2.7 Other issues
Recognition exemption
A company can elect not to apply the lessee accounting rules to short-term leases
(lease with a lease term of 12 months or less) and leases for assets of low value
(e.g. lap-tops and mobile phones).
The election must be made by class of short term leases but may be made on an
asset by asset basis for low value assets.
If such an election is made, the rental costs of the assets are recognised in profit
or loss on a straight line basis or some other systematic basis if that gives a better
reflection of the benefit arising from the asset.
Portfolio application
The rules in IFRS 16 set out the accounting rules for individual leases.
However, the rules may be applied to a portfolio of leases similar characteristics.
In other words, and entity can account for a number of separate leases as a single
lease.
This is only allowed if there is a reasonable expectation that this would not cause
the financial statements to differ materially from applying the rules to the individual
leases within that portfolio.
2.8 Presentation

Right-of-use assets must either be presented separately in the statement of
financial position or disclosed in the notes.
If not presented separately, right-of-use assets are included in the same line item
as the corresponding underlying assets would be if they were owned and this must
be disclosed.
This does not apply to right-of-use assets that meet the definition of investment
property, which must be presented in the statement of financial position as
Lease liabilities must either be presented separately in the statement of financial
position or disclosed in the notes. If not presented separately, the line item in
which they are included must be disclosed.


Interest expense on the lease liability must be presented separately (as a
component of finance costs) from the depreciation charge for the right-of-use
asset.
Statement of cash flows

Cash payments for the principal portion of the lease liability must be classified
within financing activities.
Cash payments for the interest portion of the lease liability are classified by
applying the requirements in IAS 7: Statement of Cash Flows for interest paid.
Short-term lease payments, payments for leases of low-value assets and variable
lease payments not included in the measurement of the lease liability are classified
within operating activities.
2.9 Disclosure
Information is provided that, together with the information provided in main
financial statements gives users a basis to assess the effect that leases have on
the financial position, financial performance and cash flows of the lessee.
Information is disclosed in a single note (or separate section of the financial
statements). However, information already presented elsewhere in the financial
statements, does not need to be duplicated as long as the information is
incorporated by cross-reference in the single note or separate section about
leases.
The following must be disclosed:
‰ depreciation charge for right-of-use assets by class of underlying asset;
‰ interest expense on lease liabilities;
‰ expense relating to:
x short-term leases accounted for by applying the recognition
exemption (but not that relating to leases with a lease term of one-
month orl ess);
x leases of low-value assets accounted for by applying the recognition
exemption (but not that relating to short-term leases of low-value
assets included above);
x variable lease payments not included in the measurement of lease
liabilities;
‰ income from subleasing right-of-use assets;
‰ total cash outflow for leases;
‰ additions to right-of-use assets;
‰ gains or losses arising from sale and leaseback transactions; and
‰ the carrying amount of right-of-use assets at the end of the reporting period
by class of underlying asset.
These disclosures should be given in a tabular format, unless another format is
more appropriate. Amounts disclosed must include costs that are included in the
carrying amount of another asset during the reporting period.

Financial reporting
The IAS 40: Investment property disclosures apply to right-of-use assets that
meet the definition of investment property.
Disclosure requirements of IAS 16: Property, plant and equipment apply to right-
of-use assets at revalued in accordance with that standard.
IFRS 7; Financial Instruments: Disclosures requires a maturity analysis for non-
derivative financial liabilities. The requirement is to provide information on the
contracted undiscounted future cash. A similar disclosure must be provided for
lease liabilities separately from the maturity analyses of other financial liabilities.
As this is a disclosure of undiscounted cash flows it will not agree with the balance
of the liabilities in the statement of financial position which represent discounted
amounts. However, the two can be reconciled be deducting future finance
charges from the undiscounted amount.
Example: Lease liability maturity analysis

Using the example used in section 2.6 to show the disclosures as at the end of
the first year.
lease payments
N
No later than 1 year 100,00
Later than 1 year and no later than 5
year (4u18,000 + 8,000) 340,000
Later than 5 years
440,000
Less finance charge that relates to future
periods (113,506 –34,1201 (79,386)
Present value of lease liabilities (the total
lease liability)
1The finance charge that relates to future periods is the total

finance chargeless the finance charge already expensed.

3 CHAPTER REVIEW
„ Prepare and present extracts of financial statements in respect of lessee
accounting

Financial reporting
N
×N
Minus: Cash price of the asset (10,000)
Total finance charge 2,063
Actuarial method
Year ended 31 Opening Lease Capital Interest at Closing
December balance payment outstanding 22.25% balance
N N N N N
Year 1 10,000 (4,021) 5,979 1,330 7,309
Year 2 7,309 (4,021) 3,288 733 4,021
Year 3 4,021 (4,021) – – –
N in
The non-current liability is the liability at the start of the next year after
N 288).
The current liability is the payment in year 2 less any interest contained in it
that has not yet accrued.
N
Current liability, end of Year 1
Non-currentliability, end of Year1
Total liability, end of Year 1 7,309
* 4,021 can be divided into 1,330 of interest payable and 2691 of principal payable

CHAPTER
Contents
Provisions: Recognition
Provisions: Measurement
Provisions: Double entry and disclosure
Guidance on specific provisions
Contingent liabilities and contingent assets
Chapter review

Financial reporting
INTRODUCTION
Aim
Detailed syllabus
statements
6 Provisions, contingent liabilities and contingent assets and events after
the reporting period (IAS 37 and IAS 10)
Calculate, where necessary, discuss and account for provisions, contingent
liabilities and assets as well as events after the reporting period in accordance
with the provisions of relevant accounting standards (IAS 37 and IAS 10).
Exam context
This chapter explains the rules on recognition of provisions. It also explains the necessary
disclosures in respect of contingencies

„ Define liability, provision, contingent liability and contingent asset
„ Distinguish between provisions, contingent liabilities or contingent assets
„ Understand and apply the recognition criteria for provisions under IFRS
„ Calculate/ measure provisions
„ Account for changes in provisions
„ Report provisions in final accounts

Chapter 13: IAS 37: Provisions, contingent liabilities and contingent assets
1 PROVISIONS: RECOGNITION
Introduction
Recognition criteria for provisions
Present obligation
Obligation arising out of a past event
Probable outflow of economic benefits
1.1 Introduction
The first five sections of this chapter explain rules set out in IAS 37: Provisions,
contingent liabilities and contingent assets.
Definitions
Provisions are liabilities of uncertain timing or amount.
A liability is a present obligation of the enterprise arising from past events, the
settlement of which is expected to result in an outflow from the enterprise of
resources embodying economic benefits.
An obligating event is an event that creates a legal or constructive obligation that
results in an enterprise having no realistic alternative to settling that obligation.
Provisions differ from other liabilities because there is uncertainty about the
timing or amount of the future cash flows required to settle the liability.
Accruals are liabilities to pay for goods or services that have been received or
supplied but not yet invoiced. There is often a degree of estimation in the
measurement of accruals but any inherent uncertainty is much less than for
provisions.
IAS 37 applies to all provisions and contingencies apart from those covered by
the specific requirements of other standards.
In some countries the term “provision” is also used to describe the reduction in
the value of an asset. For example accountants might talk of provision for
depreciation, provision for doubtful debts and so on. These “provisions” are not
covered by this standard which is only about provisions that are liabilities.
Major accounting issues

There are three issues to address in accounting for provisions:
‰ whether or not a provision should be recognised;
‰ how to measure a provision that is recognised; and
‰ what is the double entry on initial recognition of a provision and how is it
remeasured on subsequent reporting dates.

Financial reporting
1.2 Recognition criteria for provisions

A provision should be recognised when:
‰ a company has a present obligation (legal or constructive) 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.
If one of these conditions is not met then a provision cannot be recognised.
1.3 Present obligation

An obligation must exist in order for a provision to be recognised.
An obligation may be legal or constructive.
‰ A legal obligation is one arising from a contract, or some other aspect of
the law.
‰ A constructive obligation is one arising from the company’s actions,
whereby
x through established past practice, published policies, or a specific
current statement, the company has indicated to other parties that it
will accept certain responsibilities; and
x as a result, the company has created a valid expectation that it will
discharge those responsibilities.
Example: Constructive obligation

A clothing retailer has a policy of taking back items of clothing that customers have
purchased, and refunding the purchase price, simply because the purchaser has
changed his or her mind about he item.
The retailer does not have a legal obligation to do this under the consumer
protection legislation that applies in the jurisdiction in which it operates.
If this is the usual practice of a particular retailer, and the retailer’s policy is well-
known or has been made known to customers, then a constructive obligation
exists whenever a sale is made.
A provision would be recognised for sales returns subject to the other two criteria
being satisfied.
In most cases it will be clear that a past event has given rise to a present
obligation. However, in rare cases this may not be the case. In these cases, the
past event is deemed to give rise to a present obligation if it is more likely than
not that a present obligation exists at the end of the reporting period. This
determination must be based on all available evidence.

1.4 Obligation arising out of a past event

A past event that leads to a present obligation is called an obligating event. For
this to be the case it is necessary that the company has no realistic alternative to
settling the obligation created by the event.
This is the case only:
‰ where the settlement of the obligation can be enforced by law; or
‰ in the case of a constructive obligation, where the event (which may be an
action of the company) creates valid expectations in other parties that the
company will discharge the obligation.
The event leading to the obligation must be past, and must have occurred before
the end of the reporting period when the provision is first recognised. No provision
is made for costs that may be incurred in the future but where no obligation yet
exists.
Illustration:
A company is planning a reorganisation. These plans are in an early stage.
There is no obligation (legal or constructive) to undertake the reorganisation. The
company cannot create a provision for reorganisation costs.
Only obligations arising from past events that exist independently of a company's
future actions are recognised as provisions.
Example:
Lagos Properties owns a series of high rise modern office blocks in several major
cities in Nigeria.
The government introduces legislation that requires toughened safety glass tobe
fitted in all windows on floors above the ground floor. The legislation only applies
initially to new buildings but all buildings will have to comply within 5 years.
Analysis:
There is no obligating event.
Even though Lagos Properties will have to comply within 5 years it can avoid the
future expenditure by its future actions, for example by selling the buildings.There
is no present obligation for that future expenditure and no provision is recognised.
Example:
Aba Energy Company operates in a country where there is no environmental
legislation. Its operations cause pollution in this country.
Aba Energy Company has a widely published policy in which it undertakes to
clean up all contamination that it causes and it has are cord of honouring this
published policy.
Analysis:
There is an obligating event. Aba Energy Company has a constructive obligation
which will lead to an outflow of resources embodying economic benefits
regardless of the future actions of the company. A provision would be recognised
for the clean-up subject to the other two criteria being satisfied.

Financial reporting
An obligation always involves another party to whom the obligation is owed.

However, it is not necessary to know the identity of that party. It is perfectly
possible to have an obligation to the public at large or to a group of people.
Example:
Maiduguri Household Appliances Corporation gives warranties at the time ofsale
to purchasers of its products. Under the terms of the sale contract the company
undertakes to make good any manufacturing defects that become apparent within
three years from the date of sale.
In the period it has sold 250,000 appliances and estimates that about 2% will
prove faulty.
Analysis:
There is an obligating event being the sale of an item with the promise to repairit
asnecessary. The fact that Maiduguri Household Appliances Corporation does not
know which of its customers will seek repairs in the future is irrelevant to the
existence of theobligation.
A provision would be recognised for the future repairs subject to the other two
criteria being satisfied.
Note that the estimate that only 2% will be faulty is irrelevant in terms of
recognizing a provision. However, it would be important when it came to
measuring the size of the provisions. This is covered in then extsection.
An obligation always involves a commitment to another party. Therefore, a

management decision does not give rise to a constructive obligation unless it has
been communicated before the end of the reporting period to those affected by it
in a sufficiently specific manner to raise a valid expectation in them that the
company will discharge its responsibilities.
Example:
On13 December Jos Engineering decided to close a factory. The closure will
lead to100 redund ancies at a significant cost to the company.
At31December no new soft his plan had been communicated to the
workforce. Analysis:
There is no obligating event. This will only come into existence when
communication of the decision and its consequences are communicated to the
workforce.
An event may not give rise to an obligation immediately but may do so at a later
date due to a change in circumstances. These include:
changes in the law; or
where an act of the company (for example, a sufficiently specific public
statement) gives rise to a constructive obligation.
If details of a proposed new law have yet to be finalised, an obligation arises only
when the legislation is virtually certain to be enacted as drafted.

1.5 Probable outflow of economic benefits

The outflow of benefits must be probable. ‘Probable’ is defined by IAS 37 as
‘more likely than not to occur’.
Illustration:
A company may have given a guaranteee but may not expect to have to
honour it.
Noprovisionarisesbecauseapaymentundertheguaranteeisnotprobable.
More likely than not implies a greater than 50% chance but be careful to think
about this in the right way.
Example:
Maiduguri Household Appliances Corporation gives warranties at the time ofsale
to purchasers of its products. Under the terms of the sale contract the company
undertakes to make good any manufacturing defects that become apparent within
three years from the date ofsale.
In the period it has sold 250,000 appliances and estimates that about 2% will
prove faulty.
Analysis:
The outflow of benefits is probable. It is more likely than not that 2% will be faulty.
(In other words there is more than a 50% chance that 2% of items will prove to be
faulty).

Financial reporting
2 PROVISIONS: MEASUREMENT
Section overview
„ Introduction
„ Uncertainties
„ Time value
„ Future events
„ Reimbursements
2.1 Introduction
The amount recognised as a provision must be the best estimate, as at the end
of the reporting period, of the future expenditure required to settle the obligation.
This is the amount that the company would have to pay to settle the obligation at
this date. It is the amount that the company would have to pay a third party to
take the obligation off its hands.
The estimates of the outcome and financial effect of an obligation are made by
management based on judgement and experience of similar transactions and
perhaps reports from independent experts.
Risks and uncertainties should be taken into account in reaching the best
estimate. Events after the reporting period will provide useful evidence. (Events
after the reporting period are dealt with in more detail later.)
2.2 Uncertainties
Uncertainties about the amount to be recognised as a provision are dealt with by
various means according to the circumstances.
In measuring a single obligation, the best estimate of the liability may be the most
likely outcome. However, other possible outcomes should be considered. If there
are other possibilities which are mostly higher or mostly lower than the most likely
outcome, then the best estimate will be a higher or lower amount.

Example:
Gombe Prefabricators Limited (GPL) has won a contract to provide temporary
accommodation for workers involved in building a new airport. The contract
involves the erection of accommodation blocks on a public park and two years
later the removal of the blocks and there in statement of the site.
The blocks have been built and it is now GPL’s year-end.
GPL estimates that the task of removing the blocks and reinstating the park to its
present condition might be complex, resulting in costs with a present value of
N2,000,000, orstraight forward, resulting in costs with a present value of
N1,300,000.
GPL estimates that there is a 60% chance of the job being straight forward.
Should a provision be recognised and if so at what value?
Analysis
Should a provision be recognised?
Isthereapresentobligationasa Yes. A present obligation arises
result of a pastevent? due to the existence of a
contractual term and the building
of the block.
Is it probable that there will be an Yes. This is certain.
outflow of economic benefits to
settle the obligation
Can are liable estimate be made Yes. Data is available.
of the amount of the obligation?
A provision should be recognised.
How should the provision be measured? (What is the best estimate

of expenditure required to settle the obligation?)
The most likely outcome is that the job will be straight forward. Inthis
case the provision would be recognized at N1,300,000.
However, there is a significant chance that the job will be complex so
perhaps GPL should measure the liability at the higher amount. This
may sound a little vague but in practice this comes down to a matter of
judgement.

Financial reporting
When there is a large population of potential obligations (for example, a provision

for multiple claims under guarantees) the obligation should be estimated by
calculating an expected value of the cost of the future obligations. This is done by
weighting all possible outcomes by their associated probabilities.
Example:
Sokoto Manufacturing has sold N10,000 units in the year. Sales accrued evenly
over the year.
It estimates that for every 100 items sold, 20 will requires mallrepairs at a cost of
N N
major N
On average the need for are pair becomes apparent 6 months
afterasale. What is the closing provision?
A provision will be required for the sales in the second six months of the year as
presumably the repairs necessary in respect of the sales in the first six months
have been completed by the year end.
Sales accrue evenly, therefore, the sales in the second six months are 5,000 units
(6/12 u10,000).
Repair Number Cost per repair (N) Total (N)

Small 20% u5,000 = 1,000 100 100,000
Substantial 10% u5,000 = 500 400 200,000
Major 5% u5,000 = 250 800 200,000
Provision 500,000
Note that this would be reduced by there pairs already made by the year end
2.3 Time value

Where the effect of the time value of money is material, a provision is measured
at the present value of the expenditures expected to be required to settle the
obligation.
The discount rate used should be 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.
The need to discount is often found when accounting for decommissioning
liabilities. These are discussed in section 2.4.

Example:
Gombe Prefabricators Limited (GPL) has won a contract to provide
temporary accommodation for workers involved in building a new airport.
The contract involves the erection of accommodation blocks on a public
park and two years later the removal of the blocks and the reinstatement of
the site.
The blocks have been built and it is now 31 December 20X8 (GPL’s year-end).
in N
blocks and reinstate the site.
The pre-tax discount rate that reflects current market assessments of the time
value of money and the risks specific to the liability is 10%.
The provision that should be recognized at 31 December 20X8 is as follows:
2.4 Future events

Expected future events may be important in measuring provisions. For example,
a company may believe that the cost of cleaning up a site at the end of its life will
be reduced by future changes in technology.
The measurement of an obligation must take expected future changes into
account where there is sufficient objective evidence that they will occur. In such
cases the measurement of the provision should be based on the reasonable
expectations of technically qualified, objective observers, taking account of all
available evidence as to the technology that will be available at the time of the
clean-up.
This means that a company might include expected cost reductions associated
with increased experience in applying existing technology or the expected cost of
applying existing technology to a larger or more complex clean-up operation than
has previously been carried out.
One future event might be the effect of possible new legislation.
The measurement process should take this into account when there is sufficient
objective evidence that the legislation is virtually certain to be enacted.
In practice, the proceeds of the sale of an asset in the future might be used to
pay for an event for which a provision is recognised today. However, gains from
the expected disposal of assets must not be taken into account in measuring a
provision.

Financial reporting
2.5 Reimbursements
In some cases, a part or all of a company’s provision may be recoverable from a
third party. For example, a company paying out to a customer under the terms of
a guarantee may itself be able to claim money back from one of its own
suppliers.
IAS 37 requires that such a reimbursement:
‰ should only be recognised where receipt is virtually certain; and
‰ should be treated as a separate asset in the statement of financial position
(i.e., not netted off against the provision) at an amount not greater than that
of the provision.
However, IAS 37 allows the expense relating to a provision to be presented net
of the amount recognised for a reimbursement in the statement of profit or loss.

3 PROVISIONS: DOUBLE ENTRY AND DISCLOSURES
Introduction
Measurement on initial recognition
Use of provisions
Subsequent measurement
Disclosures about provisions
3.1 Introduction
IAS 37 is about the recognition and measurement of provisions which are of
course a credit balance. It gives little guidance on the recognition of the debit
entry on initial recognition of a provision saying that whether an expense or asset
is recognised is left to guidance in other standards.
3.2 Measurement on initial recognition

In most cases the debit entry that arises when a provision is recognised is an
expense. There is one important case where it is capitalised as an asset (on
recognition of a decommissioning liability) and this is discussed later.
Illustration: Usual double entry on initial recognition of a provision

Debit Credit
Profit or loss (expense) X
Provision X
3.3 Use of provisions

A provision is set up to recognise an expense (usually) that exists at the reporting
date. When the expense is paid the following double entry is used:
Credit
Cash
If the provision is more than the amount needed to settle the liability the balance
is released as a credit back through the income statement.
If the provision is insufficient to settle the liability an extra expense is recognised.
IAS 37 also states that a provision may be used only for expenditures for which
the provision was originally recognised.

Financial reporting
Example: Use of provisions

A company has created a provision of N300,000 for the cost of warranties and
guarantees.
The company now finds that it will probably has to pay N250,000 to settle a legal
dispute.
It cannot use the warranties provision for the costs of the legal dispute. An extra
N250,000 expense must be recognised.
3.4 Subsequent measurement

Each provision must be reviewed at the end of each reporting period. This might
result in derecognition of a provision that no longer meets the recognition criteria
or in the re-measurement of a provision. An increase in a provision would result
in the recognition of a further expense or a reduction in expense as the
previously recognised provision is reduced through a credit to profit or loss.
Debit Credit
Provision
Income statement
Profitor loss
(expense)
Provision
Provision
Profit or loss

Example: Subsequent measurement

31 December 20X7
A company was sued by a customer in the year ended 31 December 20X7.
Legal advice is that the customer is virtually certain to win the case as several
similar cases have already been decided in the favour of the injured parties.
At 31 December 20X7, the company’s lawyer was of the opinion that, the cost of the
settlement would be N1,000,000.
A provision is recognized in the amount of N1,000,000 as follows (reducing profit
for the year by that amount).
Debit (N) Credit (N)
Expenses 1,000,000
Provision 1,000,000
31 December 20X8
The claim has still not been settled. The lawyer now advises that the claim will
probably be settled in the customer’s favourat N1,200,000.
The provision is in creased to N1,200,000 as follows.
Debit (N) Credit (N)
Expenses 200,000
Provision 200,000
31 December 20X9
The claim has still not been settled. The lawyer now believes that the claim
will be settled at N900,000.
The provision is reduced to N900,000 as follows.
Debit(N) Credit(N)
Provision 300,000
Expenses 300,000
The reduction in the provision increases profit in the year and the provision in the
statement of financial position is adjusted down to the revised estimate of
N900,000.
31 December 20X9
The claim is settled for N950,000. On settlement, the double entry in the ledger
accounts will be:
Debit (N) Credit(N)
Expenses 50,000
Provision
Cash 900,000 950,000
The charge against profit on settlement of the legal claimis N50,000.
The provision no longer exists. The total amount charged against profit over
the four years was the final settlement figure of N950,000.

Financial reporting
When a provision is included in the statement of financial position at a discounted

value (at present value) the amount of the provision will increase over time, to
reflect the passage of time. In other words, as time passes the amount of the
discount gets smaller, so the reported provision increases. This increase in value
is included in borrowing costs for the period.
3.5 Disclosures about provisions

IAS 37 requires the following disclosures about provisions in notes to the
For each class of provision:
‰ the opening and closing balances and movements in the provision during
the year;
‰ a brief description of:
x the nature of the obligation;
x the expected timing of any settlement; and
x an indication of the uncertainties surrounding the amount and timing
of any settlement.

4 GUIDANCE ON SPECIFIC PROVISIONS
Onerous contracts
Future operating losses
Restructuring
Decommissioning liabilities and similar provisions
Future repairs to assets
IAS 37 explains how its rules apply in given circumstances. Some of the guidance is in
the body of the standard and some in an appendix to the standard.
4.1 Onerous contracts
Definition
An onerous contract is a contract where the unavoidable costs of
fulfilling/completing the contract now exceed the benefits to be received (the
contract revenue).
A provision should be made for the additional unavoidable costs of an onerous

contract. (The ‘additional unavoidable costs’ are the amount by which costs that
cannot be avoided are expected to exceed the benefits).
Example: Onerous contract

On31December20X8, company His three years through a five year contract to
buy10,000 units of a component per annum at a price of N100per unit.
The units are incorporated into a finished product that previously sold for N150 per
unit. A substitute product for the finished good has recently entered the market.
This product sells for N90 per unit and is superior to the original product.
Company H has decided to withdraw from this market but is still committed to
the remaining two years of the supply contract.
The market price of the component has fallen to N75 per unit and it is probable
that Company H could sell the components at this price.
Analysis
A present legal obligation exists as a result of a past event (the signing of the
supply contract).
An outflow of resources is probable. (These are the payments to buy the
components for the remainder of the term of the supply contract).
The amount can be measured reliably (10,000 unitsu2yearsu N(100–75))=
N500,000.
The discounted value of the future net payments for two years would be
recognised as a provision.

Financial reporting
Example: Onerous contract

Ogbomosho Clothing has a contract to buy 300 metres of silk from a supplier
each month for N3,000 per metre.
Ogbomosho Clothing had a contract with a Dubai retailer to sell each dress for
N5,000 but this retailer has fallen into administration and the administrator shave
cancelled the contract as they were entitled to do under one of its clauses.
Ogbomosho Clothing cannot sell the dresses to any other customer.
The contract to buy the silk can be cancelled with three months’
notice. Analysis
The company can cancel the contract but must pay for the next three months
deliveries:
Cost (300m × N3,000 × 3 months) N2,700,000 A provision should be
recognised for this amount.
4.2 Future operating losses

A company may forecast that it will make a substantial operating loss in the next
year or several years. If so, its directors might want to ‘take all the bad news’
immediately, and create a provision for the future losses.
Provisions cannot be made for future operating losses. This is because they arise
from future events, not past events.
4.3 Restructuring
A company may plan to restructure a significant part of its operations. Examples
of restructuring are:
‰ the sale or termination of a line ofbusiness
‰ the closure of business operations in a country or geographical region, or
relocation of operations from one region or country toanother
‰ major changes in management structure, such as the removal of an entire
‘layer’ of management from the managementhierarchy
‰ fundamental reorganisations changing the nature and focus of the
company’soperations.
A provision is recognised for the future restructuring costs only if a present
obligation exists.

A constructive obligation to restructure arises only when a company:

has a detailed formal plan for the restructuring identifying a tleast:
x the business or part of a business concerned;
x the principal locations affected;
x the location, function, and approximate number of employees who will
be compensated for terminating their services;
x the expenditures that will be undertaken; and
x when the plan will be implemented; and
‰ has raised a valid expectation in those affected that it will carry out the
restructuring by starting to implement that plan or announcing its main
features to those affected by it.
A restructuring decision made before the end of the reporting period does not
give rise to a constructive obligation unless the company has:
‰ started to implement the plan; or
‰ announced the main features of the plan to those affected by it in a
sufficiently specific manner to raise a valid expectation in them that the
restructuring will occur.
A company might start to implement a restructuring plan, or announces its main
features to those affected, after the reporting period but before the financial
statements are authorised for issue.
Disclosure is required under IAS 10 Events after the Reporting Period if the
restructuring is material.
A restructuring provision must only include the direct expenditures arising from
the restructuring. These are those that are both:
‰ necessarily entailed by the restructuring; and
‰ not associated with the ongoing activities of the company.
A restructuring provision would not include costs that are associated with ongoing
activities such as:
i. retraining or relocating continuing staff;
ii. marketing; or
iii. investment in new systems, etc.

Financial reporting
4.4 Decommissioning liabilities and similar provisions

A company may be required to ‘clean up’ a location where it has been working
when production ceases.
This is often the case in industries where companies are only granted licenses to
operate on condition that they undertake to perform future clean-up operations.
Such industries include, oil and gas, mining and nuclear power.
For example, a company that operates an oil rig may have to repair the damage
it has caused to the sea bed once the oil has all been extracted.
The normal rules apply for the recognition of a provision: a company recognises
a provision only where it has an obligation to rectify environmental damage as a
result of a past event.
A company has an obligation to ‘clean-up’ a site if:
‰ it is required to do so by law (a legal obligation); or
‰ its actions have created a constructive obligation to doso.
A constructive obligation might exist if (for example) a company has actually
promised to decontaminate a site or if it has adopted environmentally friendly
policies and has made the public aware of this.
Accounting for a provision for a decommissioning liability

IAS 16 Property, plant and equipment identifies the initial estimate of the costs of
dismantling and removing an item and restoring the site upon which it is located
as part of the cost of an asset.
Future clean-up costs often occur many years in the future so any provision
recognised is usually discounted to its present value.
Debit Credit
Non-current asset X
Provision
The asset is depreciated over its useful life in the same way as other non-current
assets.
The provision is remeasured at each reporting date. If there has been no change
in the estimates (i.e. the future cash cost, the timing of the expenditure and the
discount rate) the provision will increase each year because the payment of the
cash becomes one year closer. This increase is described as being due to the
unwinding of the discount.
The amount due to the unwinding of the discount must be expensed.

Example: Deferred consideration

A company has constructed an oil rig which became operational on 1 January
20X8.
The company has contracted to remove the oilrigandall associated infrastructure
and to restore the site to repair any environmental damage to the site on
completion of drilling activity.This is estimated to be at a cost of N8,000,000 in 10
years’time.
The pre-tax rate that reflects current market assessments of the time value of
money and the risks specific to the liability is 10%.
1 January 20X8 – Initial measurement

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Debit Credit
Asset 3,084,346
Provision 3,084,346
31 December 20X8
The provision is remeasured as:
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Provision: N
Balance b/f 3,084,346
Interest expense (the unwinding of the discount) 308,435
Balance c/f 3,392,781
The asset is depreciated (say on a straight line)

Asset: N
Cost 3,084,346
Depreciation (N 8,000,000/10years) (308,435

Carrying amount 7,200,000
Double entry:
Debit Credit
Profit or loss (interest expense) 308,435
Provision 308,435
Profit or loss(depreciation expense) 308,435


Financial reporting
A provision for making good environmental damage might be recognised both on

when an asset is installed and then increased as the asset is used.
Example:
A company is about to begin to operate a coal mine. At the end of the reporting period,
the mineshaft has been prepared and all the necessary equipment has been
constructed and is in place, but no coal has yet been extracted.
Under local law, the company is obliged to rectify all damage to the site once the
mining operation has been completed (this is expected to be several years from now).
Management estimates that 20% of the eventual costs of performing this work will
relate to plugging the mine and removing the equipment and various buildings and
the remaining 80% will relate to restoring the damage caused by the actual extraction
of coal.
Analysis
The company has a legal obligation to rectify the environmental damage caused by
the actual digging of the mineshaft and construction of the site. An outflow of
economic benefits is probable.
Therefore, the company should recognise a provision for the best estimate of
removing the equipment and rectifying other damage which has occurred to date.
This is expected to be about 20% of the total cost of restoring the site.
Because no coal has yet been extracted, the company has no obligation to rectify any
damage caused by mining. No provision can be recognised forth is part of the
expenditure (estimate data bout 80% of the total).
4.5 Future repairs to assets

Some assets need to be repaired or to have parts replaced at intervals during
their lives.
For example, suppose that a furnace has a lining that has to be replaced every
five years. If the lining is not replaced, the furnace will break down.
Before IAS 37 was issued, companies would often recognise provisions for the
cost of future repairs or replacement parts. These might be built up in instalments
over the life of the asset or the relevant part of the asset.
IAS 37 effectively prohibits this treatment. The reasoning behind this is that a
company almost always has an alternative to incurring the expenditure, even if it
is required by law (for example, for safety reasons). For example, the company
which has to replace the lining of its furnace could sell the furnace or stop using
it, although this is unlikely in practice.
IAS 37 states that a provision cannot be recognised for the cost of future repairs
or replacement parts unless the company has an obligation to incur the
expenditure, which is unlikely. The obligating event is normally the actual repair
or purchase of the replacement part.

Instead of recognising a provision, a company should capitalise expenditure

incurred on replacement of an asset and depreciate this cost over its useful life.
This is the period until the part needs to be replaced again. For example, the cost
of replacing the furnace lining should be capitalised, so that the furnace lining is a
non-current asset; the cost should then be depreciated over five years. (Note: IAS
16: Property, plant and equipment states that where an asset has two or more
parts with different useful lives, each part should be depreciated separately.)
Normal repair costs, however, are expenses that should be included in profit or
loss as incurred.

Financial reporting
5 CONTINGENT LIABILITIES AND CONTINGENT ASSETS
Definitions
Recognising contingent liabilities or contingent assets
Disclosures about contingent liabilities and contingent assets
Summary: liabilities, provisions, contingent liabilities and contingent assets
5.1 Definitions
‘Contingent’ means ‘dependent on something else happening’.
Contingent liability
A contingent liability is one that does not exist at the reporting date but may do so
in the future or it is a liability that exists at the reporting date but cannot be
recognised because it fails one of the IAS 37 recognition criteria.
Definition: Contingent liability

A contingent liability is either of the following:
A contingent liability is 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
A contingent liability is a present obligation that arises from past events but isnot
recognised because it is not probable that an outflow of economic benefits will be
required to settle the obligation or the amount of the obligation cannot be
measured with sufficient reliability.
IAS 37 makes a distinction between:

‰ provisions – which are recognised as liabilities (assuming that a reliable
estimate can be made) because they are present obligations and it is
probable that an outflow of resources embodying economic benefits will be
required to settle the obligations; and
‰ contingent liabilities – which are not recognised as liabilities because they
areeither:
x possible obligations;
x present obligations that do not meet the recognition criteria for
provisions because either:
– it is not probable that an outflow of resources embodying
economic benefits will be required to settle the obligation; or
– a sufficiently reliable estimate of the amount of the obligation
cannot bemade).

Example:
Company G is involved in a legal dispute with a customer, who is making a claim
against Company G for losses it has suffered as a consequence of a breach of
contract.
If Company G’s lawyers believe that the likelihood of the claim succeeding is
possible rather than probable, then the claim should be treated as a contingent
liability and not as a provision.
Contingent asset
Definition: Contingent asset

A contingent asset is a possible asset that arises from past events 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.
An example of a contingent asset might be a possible gain arising from an

outstanding legal action against a third party. The existence of the asset (the
money receivable) will only be confirmed by the outcome of the legal dispute.
5.2 Recognising contingent liabilities or contingent assets

Contingent liabilities and contingent assets are not recognised in the financial
statements.
In some circumstances, information about the existence of a contingent asset or a
contingent liability should be disclosed in the notes to the financial statements.
‰ Contingent liabilities should be disclosed unless the possibility of any
outflow in settlement is remote (the meaning of ‘remote’ is not defined in
IAS 37).
‰ Contingent assets should be disclosed only if an inflow in settlement is
probable. ’Probable’ is defined by IAS 37 as ‘more likely than not’. (And if
an inflow is certain, the item is an actual asset that should be recognised in
the statement of financial position.)
5.3 Disclosures about contingent liabilities and contingent assets

Where disclosure of a contingent liability or a contingent asset is appropriate, the
following disclosures are required:
‰ A brief description of the nature of the contingent liability/asset
‰ Where practicable:
x an estimate of its financial effect
x an indication of the uncertainties.
‰ For contingent liabilities, the possibility of any reimbursement.

Financial reporting
5.4 Summary: liabilities, provisions, contingent liabilities and contingent

assets
The following table provides a summary of the rules about whether items should
be treated as liabilities, provisions, contingent liabilities or contingent assets.
Contingent
Criteria Provision Contingent liability
asset
Present Yes Yes No (but may Only a
obligation/ come into possible
asset arising existance in asset
from past the future)
events?
Will Probable Not probable Outflow to be Inflow to be
settlement outflow – and outflow – or a confirmed by confirmed by
result in a reliable reliable uncertain uncertain
outflow/ estimate can estimate future events future events
inflow of be made of cannot be
economic the obligation made of the
benefits? obligation
Treatment in Recognise a Disclose as a Disclose as a Only disclose
the financial provision contingent contingent if inflow is
statements liability liability probable
(unless the (unless the
possibility of possibility of
outflow is outflow is
remote) remote)
Decision tree
An Appendix to IAS 37 includes a decision tree, showing the rules for deciding
whether an item should be recognised as a provision, reported as a contingent
liability, or not reported at all in the financial statements.

Practicequestion 1
Sokoto Transformers Ltd (STL) is organised into several divisions.
The following events relate to the year ended 31 December 20X8.
1 A number of products are sold with a warranty. At the beginning of
the year the provisions to odat N750,000.
A number of claims have been settled during the period for N400,000.
As at the year end there were unsettled claims from 150 customers.
Experience is that 40% of the claims submitted do not fulfil warranty
conditions and can be defended at no cost.
The average cost of settling the other claims will be N7,000 each.
2 A transformer unit supplied to Rahim YarKhan District Hospital
exploded during the year.
The hospital has initiated legal proceedings for damages of N10 million
against STL.
STL’s legal advisors have warned that STL has only a 40% chance
of defending the claim successfully. The present value of this claim
has been estimated at N9million.
The explosion was due to faulty components supplied to STL for
inclusion in the transformer. Legal proceedings have been started
against the supplier. STL’s legal advisors say that STL have a very
good chance of winning the case and should receive 40% of the
amount that they have to pay to the hospital.
3 On1July 20X8 STL entered into a two-year, fixed price contract
to supply a customer 100 units per month.
Thefore cast profit perunit was N1,600 but, due to unforeseen cost
increasesand production problems, each unit is anticipated to make a
loss of N800.
4 On1July 20X7 one of STL’s divisions has commenced the extraction
of minerals in an overseas country. The extraction process causes
pollution progressively as theories extracted.
There is no environmental clean-up law enacted in the country.
STL made public statements during the licence negotiations that as
a responsible company it would restore the environment at the end
of the licence.
STL has alicnce to operate for 5 years. At the end of five years
the cost of cleaning (on the basis of the planned extraction) will
be:
N5,000,000.
Extraction commenced on1July 20X8 and is currently at planned
levels.
Required:
Prepare the provisions and contingencies note for the financial
statements for the year ended 31December 20X8, including narrative
commentary.

Financial reporting
6 CHAPTER REVIEW
Define liability, provision, contingent liability and contingent asset
Distinguish between provisions, contingent liabilities or contingent assets
Understand and apply the recognition criteria for provisions under IFRS
Calculate/ measure provisions
Account for changes in provisions
Report provisions in final accounts

SOLUTION TO PRACTICE QUESTION

Solution: Provisions and contingencies 1
Legal Onerous Clean-up
Warranty claim contract costs Total

N000 N000 N000 N000 N000
At 1 January
20X8 750 nil nil 500 1,250
Used in the
year (400) (400)
Statement of
profit or loss
(balance) 280 9,000 1,440 1,000 11,720
At31
December
20X8 630 9,000 1,440 1,500 12,570
W1 W2 W3 W4
Warranty: The company grants warranties on certain categories of

goods. The measurement of the provision is on the company’s
experience of the likelihood and cost of paying out under the warranty.
Legal claim: The legal claim provision is in respect of a claim made
by a customer for damages as a result of faulty equipment supplied by
the company. It represents the present value of the amount at which
the company's legal advisors believe the claim is likely to be settled.
Onerous contract: The provision for the onerous contract is in respect of
a two-year fixed-price contract which the company entered into on 1 July
20X8. Due to unforeseen cost increases and production problems,
alosson this contract is now anticipated. The provision is based on the
amount of this loss up to the end of the contract.
Clean-upcosts: The provision for clean-up costs is in respect of
the company's overseas mineral extractionn operations.
The company is 18 months into a five year operating licence. The
estimatecost of cleaning up the site at the end of the five years is
N5,000,000.A provision of N1,000,000 per annum is recognised.
Contingent asset: The company is making a claim against a supplier of

components. These components led in part to the legal claim agains tthe
company for which a provision has been made above. Legal advice is
that this claim is likely to succeed and should amount to around 40% of
the total damages (N3.6 million).
W1 Warranty provision:150u N7,000u 60% = N30,000.

W2 Onerous contract:18monthsu100 unitsu N800 = N1,440,000.
W3 Clean up costs: N1,000,000 per annum as it is the extraction
that causes the cost.

Skills level R
E
T
P
A
H
C
Accounting for taxation

Deferred tax: Introduction
Recognition of deferred tax: basic approach
Recognition and measurement rules
Chapter review

Financial reporting
INTRODUCTION
Aim
Detailed syllabus
statements
7 Income taxes (IAS 12)
Calculate (where necessary), discuss and account for income tax including
current and deferred tax in accordance with the provisions of IAS 12.
Exam context
This chapter explains the accounting treatments for current tax and deferred tax.

„ Account for current tax
„ Define temporary differences
„ Identify temporary differences that cause deferred tax liabilities and deferred tax assets
„ Determine the amount of deferred tax to be recognised in respect of temporary
differences identified.
„ Apply the disclosure requirements of IAS12.

Chapter 14: IAS 12: Income taxes
1 ACCOUNTING FOR TAXATION
Taxation ofprofits
Over-estimate or under-estimate of tax from the previous year
Taxation in the statement of financial position
1.1 Taxation of profits

Companies pay tax on their profits. The tax charge is based on their accounting
profit as adjusted according to the tax law of Nigeria.
Definitions
Accounting profit is profit or loss for a period before deducting tax expense.
Taxable profit (tax loss) is the profit (loss) for a period, determined in accordance
with the rules established by the taxation authorities, upon which income taxes
are payable (recoverable).
Current tax is the amount of income taxes payable (recoverable) in respect of the
taxable profit (tax loss) for a period.
Tax computation
A series of adjustments is made against a company’s accounting profit to arrive
at its taxable profit. These adjustments involve:
‰ Adding back inadmissible deductions (accounting expenses which are not
allowed as a deduction against taxable profit).
‰ Deducting admissible deductions which include:
x expenses that are allowable as a deduction against taxable profit but
which have not been recognised in the financial statements.
x Income recognised in the financial statements but which is nottaxed.
The tax rate is applied to the taxable profit to calculate how much a company
owes in tax for the period. IFRS describes this as current tax.
An exam question might require you to perform a basic taxation computation
from information given in the question.
Accounting profit before tax

Add back: In admissible deductions
Less: Admissible deductions
Taxable profit
Tax rate
Tax payable (current tax)

Financial reporting
Example: Taxation computation

for
December 20X8.
N
N
N in
N in
N for
N
Tax regime
All borrowing costs are deductible for tax
purposes. Capital gains are not taxable.
Fines are not tax deductible.
Accounting depreciation is not allowable for tax purposes.
Capital allowance is claimable at 10% per annum for buildings and 15% per
annum for machinery applied to tax written down value at the start of the year.
Tax is paid at 30%
The tax computation is as follows:
Accounting profit 789,000

Add back in admissible deductions:
Accounting depreciation 70,000
Fine paid 125,000
195,000
Less: Admissible deductions
Tax depreciation (15% u120,000 + 10% u600,000) 78,000
Capital gain 97,000
Borrowing cost capitalised 10,000
(185,000)
Taxable profit 799,000
Tax rate 30%
Tax payable 239,700

Tax base
The above example referred to the tax written down value of the machinery and
buildings. This is the tax authority’s view of the carrying amount of the asset
measured as cost less depreciation calculated according to the tax legislation.
IFRS uses the term tax base to refer to an asset or liability measured according
to the tax rules.
Definition
The tax base of an asset or liability is the amount attributed to that asset or
liability for tax purposes.
The tax base of an asset is the amount that the tax authorities will allow as a
deduction in the future.
Measurement
Current tax liabilities (assets) for the current and prior periods must be measured
at 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.

Financial reporting
1.2 Over-estimate or under-estimate of tax from the previous year

Current tax for current and prior periods must be recognised as a liability until
paid. If the amount already paid exceeds the amount due the excess must be
recognised as an asset.
When the financial statements are prepared, the tax charge on the profits for the
year is likely to be an estimate. The figure for tax on profits in the statement of
profit or loss is therefore not the amount of tax that will eventually be payable,
because it is only an estimate. The actual tax charge, agreed with the tax
authorities some time later, is likely to be different.
In these circumstances, the tax charge for the year is adjusted for any under-
estimate or over-estimate of tax in the previous year.
‰ an under-estimate of tax on the previous year’s profits is added to the tax
charge for the current year.
‰ an over-estimate of tax on the previous year’s profits is deducted from the
tax charge for the current year.
Example: Over-estimate or under-estimate of tax
N N
Profit from operations 460,000
Interest (60,000)
Profit before tax 400,000
Tax:
Adjustment for under-estimate of tax in the
previous year 3,000
Tax on current year profits 100,000
Tax charge for the year (103,000)
Profit after tax 297,000

1.3 Taxation in the statement of financial position

The taxation charge for the year is the liability that the company expects to pay.
The timing of tax payments on profits varies from one country to another,
depending on the tax rules in each country. The actual amount of tax payable,
and reported in the statement of financial position as a current liability (taxation
payable), is calculated as follows:
Tax payable at the beginning of the

year Tax charge for the year
Tax payments made during the

year Tax payable at the end of the
year
Example: Taxation in the financial statements

Fresh Company has a financial year ending on 31 December.
for N
profits for N
for N During
the year to 31 December 20X8, the company made payments of N in
This would result in the following accounting treatment:
N
Tax on current year profits 114,000
Adjustment for over-estimate of tax in the previous year (6,000)
Taxation charge for the year 108,000
Tax liability in the statement of financial position N

Tax payable at the beginning of the year 77,000
Tax charge for the year 108,000
185,000
Tax payments made during the year (123,000)
Tax payable at the end of the year 62,000

Financial reporting
2 DEFERRED TAX: INTRODUCTION
„ Deferred taxation – Underlying problem

„ Identifying deferred tax balances
„ IAS 12 approach to the problem
2.1 Deferred taxation – Underlying problem

As explained in the last section, in most jurisdictions the rules for the recognition
and measurement of certain assets, liabilities, income and expenses for tax
purposes differ from the equivalent rules under IFRSs. This results in different
figures in the financial statements and in the tax computations/tax working
papers.
It is convenient to envisage two separate sets of accounts:
‰ one set constructed following IFRS rules; and,
‰ a second set following the tax rules (tax computations).
This results in a breakdown in the tax rate percentage relationship between the
profit before tax figure and the taxation figure. In other words the tax charge is
not the tax rate applied to the profit before tax.
Limited N in
20X1, 20X2 and 20X3 and pays tax at 30%.
Limited plant for N
be depreciated on a straight line basis over 3years.
Accounting depreciation is not allowed as a tax able deduction in the jurisdiction
in which the company operates. Instead, tax allowable depreciation (capital
allowance) is available as shown in the following tax computations:
20X1 20X2 20X3
N N N
Accounting profit (after
depreciation) 50,000 50,000 50,000
Add back depreciation 3,000 3,000 3,000
Deduct capital allowances (4,500) (2,500) (2,000)
(1,500) 500 1,000
Taxable profit 48,500 50,500 51,000
Tax @ 30% 14,550 15,150 15,300

In the absence of the recognition of deferred tax this would be reported as follows:
X Limited: Statement of profit or loss for the years ending:

20X1 20X2 20X3 Total
N N N N
Profit before tax 50,000 50,000 50,000 150,000
Incometax @ 30%
(as above) (14,550) (15,150) (15,300) (45,000)
Profit after tax 35,450 34,850 34,700 105,000
Looking at the total column, the profit before tax is linked to the taxation
figure through the tax rate (150,000 u30% = 45,000).
This is not the case in each separate year.
This is because the tax rate is not applied to the accounting profit before
tax but to that figure after adjustments.
The item of plant is written off in the calculation of both accounting profit
and taxable profit but by different amounts in different periods. The
differences are temporary in nature as over the three-year period, the
same expense is recognised for the item of plant under both the
accounting rules and the tax rules.
Transactions recognised in the financial statements in one period may have their
tax effect deferred to (or more rarely, accelerated from) another. Thus, the tax is
not matched with the underlying transaction that has given rise to it.
In the above example the tax consequences of an expense (depreciation in this
case) are recognised in different periods to when the expense is recognised.
Accounting for deferred tax is based on the principle that the tax consequence of
an item should be recognised in the same period as the item is recognised. It tries
to match tax expenses and credits to the period in which the underlying
transactions to which they relate are recognised.
In order to do this, the taxation effect that arises due to the differences between
the figures recognised under IFRS and the tax rules is recognised in the financial
statements.
The double entry to achieve this is between a deferred tax balance in the
statement of financial position (which might be an asset or a liability) and the tax
charge in the statement of profit or loss. (More complex double entry is possible
but this is outside the scope of your syllabus).
The result of this is that the overall tax expense recognised in the statement of
profit or loss is made up of the current tax and deferred tax numbers.
Definition: Tax expense

Tax expense (tax income) is the aggregate amount included in the determination
of profit or loss for the period in respect of current tax and deferred tax.

Financial reporting
2.2 Identifying deferred tax balances

The differences between the two sets of rules will result in different numbers in
the financial statements and in the tax computations.
Two perspectives
These differences can be viewed from:
‰ a statement of profit or loss (income and expenses) perspective:
x the differences arising in the period are identified by comparing
income and expenses recognised under IFRS to the equivalent
figures that are taxable or allowable under tax legislation;
x the approach identifies the deferred tax expense or credit recognised
in the statement of profit or loss for the period (with the other side of
the entry recognised as a liability or asset); or
a statement of financial position (assets and liabilities) perspective:
x the differences are identified on a cumulative basis by comparing the
carrying amount of assets and liabilities under IFRS to the carrying
amount of the same assets and liabilities according to the tax rules;
x the approach identifies the deferred tax liability (or asset) that should
be recognised (with the movement on this amount recognised as a
credit or expense in the statement of profit or loss).
IAS 12 uses the statement of financial position perspective but both will be
explained here for greater understanding.
The following table identifies the differences between the accounting treatment and
the taxation treatment of the item of plant from both perspectives.
Assets Income
Carrying and and
amount Tax base liabilities expenses
Cost at 01/01/X1 9,000 9,000
Charge for the year (3,000) (4,500) (1,500)
Cost at 31/12/X1 6,000 4,500 1,500
Charge for the year (3,000) (2,500) 500
Cost at 31/12/X2 3,000 2,000 1,000
Charge for the year (3,000) (2,000) 1,000

Statement of profit or loss perspective
Example continued: Statement of profit or loss perspective

20X1:
N3,000 is disallowed but N4,500 is allowed instead.
tax able expense is N1,500 greater than the accounting expense.
tax able profit is N1,500 less than accounting profit.
current tax is reduced by 30% of N1,500 (N450).
deferred tax expense of N450 must be recognized to restore the balance
(Dr:Tax expense/Cr:Deferred taxation liability).
20X2:
Ÿtax able expense is N500 less than the accounting expense.
Ÿtaxableprofitis N500 more than accounting profit.
Ÿ current tax is increased by 30% of N500 (N150).
Ÿ deferred tax credit of N150 must be recognized to restore the
balance (Dr: Deferred taxation liability/Cr: Tax expense).
20X3:
Ÿtax able expense is N1,000 less than the accounting expense.
Ÿtaxableprofitis N1,000more than accounting profit.
Ÿ current tax is increased by 30% of N1,000 (N300).
Ÿ deferred tax credit of N300 must be recognised to restore the
balance (Dr: Deferred taxation liability / Cr: Tax expense).
The statement of profit or loss would now be as follows:

20X1 20X2 20X3
N N N
Profit before tax 50,000 50,000 50,000
Income tax @ 30% W1 14,550 15,150 15,300
Deferred tax 450 (150) (300)
(15,000) (15,000) (15,000)
Profit after tax 35,000 35,000 35,000
Statement of financial position 20X1 20X2 20X3

Deferred tax liability: N N N
Balance b/f nil 450 300
Movement in the year 450 (150) (300)
Balance b/f 450 300 nil

Financial reporting
Statement of financial position perspective
Example continued: Statement of financial position perspective

This approach compares the carrying amount of assets and liabilities in the
financial statements to their tax base to identify the cumulative differences to that
point in time.
These differences are called temporary differences.
An asset in the financial statements compared to the taxman’s view requires the
recognition of a deferred taxliability which is measured by applying the tax rate to
the temporary difference.
Carrying Temporary Tax @
amount Tax base difference 30%
At 31/12/X1 6,000 4,500 1,500 450
At 31/12/X2 3,000 2,000 1,000 300
At 31/12/X3 nil nil nil nil
By the end of 20X1

The asset in the financial statements is N1,500 more than the tax base.
A deferred tax liability of N450 must be recognised.
Debit Credit
Tax expense 450
Deferred tax liability 450
By the end of 20X2

The asset in the financial statements is N1,000 more than the taxbase.
A deferred tax liability of N300 must be recognised but there was N450 at
the start of the year so the liability must be reduced.
Debit Credit
Tax expense 150
By the end of 20X3

The asset in the financial statements is the same as the tax base (nil).
A deferred tax liability of nil must be recognised but there was N300 at the
start of the year so the liability must be reduced.
Debit Credit
Tax expense 300
These amounts are the same as on the previous page and would have
the same impact on the financial statements.

The recognition of deferred taxation has restored therelationship between

profit before tax and the tax charge through the tax rate in each year (30%of
N50,000 N15,000).
Terminology
When a difference comes into existence or grows it is said to originate. When the
difference reduces in size it is said to reverse.
Thus, in the above example a difference of N1,500 originated in 20X1. This
difference then reversed in 20X2 and 20X3.
Warning
Do not think that an origination always leads to the recognition of a liability and an
expense. The direction of the double entry depends on the circumstances that
gave rise to the temporary difference. This is covered in section 3 of this chapter.
2.3 IAS 12 approach to the problem

IAS 12: Income taxes, advocates a statement of financial position approach.
Business must identify a deferred tax liability (or perhaps asset) at each reporting
date.
It must do this by identifying the differences between the carrying amount of
assets and liabilities in the financial statements to the tax base (tax authority’s
view of those same items). These differences are known as temporary
differences (this will be explained in more detail in the next section).
Once the temporary differences have been identified the deferred tax balance is
calculated by applying the appropriate tax rate to the difference.

Financial reporting
3 RECOGNITION OF DEFERRED TAX: BASIC APPROACH
Identifying the temporary difference

Taxable and deductible temporary differences
Accounting for deferred tax
Sources of temporary differences
3.1 Identifying the temporary difference

Accounting for deferred tax is based on the identification of the temporary
differences.
Definition: Temporary difference

Temporary differences are differences between the carrying amount of an asset
or liability in the statement of financial position and its tax base.
Temporary differences may be either:
(a) Tax able temporary differences, which 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; or
(b) deductible temporary differences, which are temporary differences that will
result in amounts that are deductible in determining tax able profit (tax loss)
of future periods when the carrying amount of the asset or liability is
recovered or settled.
The tax base of an asset is the amount that will be deductible for tax purposes
against any taxable economic benefit that will flow to an entity when it recovers
the carrying amount of the asset.
Definition: Tax base

The tax base of an asset or liability is the amount attributed to that asset or
liability for tax purposes.

3.2 Tax able and deductible temporary differences

Temporary differences may be either taxable temporary differences or deductible
temporary differences.
Taxable temporary differences

A taxable temporary difference is caused by a debit in the carrying amount of an
asset or liability in the financial statements compared to the tax base of that item.
Taxable temporary differences lead to the recognition of deferred tax liabilities.
Example: Taxable temporary differences

Each of the following is a tax able temporary difference leading to the recognition
of a deferred tax liability.
Deferred
Carrying Temporary tax liability
amount Tax base difference (30%)
Non-current asset 1,000 800 200 60
Inventory 650 600 50 15
Receivable 800 500 300 90
Receivable (note 1) 500 nil 500 150
Payable (note 2) (1,000) (1,200) 200 60
Note 1:
This implies that an item accounted for using the accruals basis in the
financial statements is being taxed on a cash bases.
If an item is taxed on cash basis the tax base would be zero as
no receivable would be recognized under the tax rules.
Note 2:
The credit balance in the financial statements is N1,000 and the tax baseis
accredit of N1,200. Therefore, the financial statements show a debit
balance of 200 compared to the tax base. This leads to a deferred tax
liability.
IAS12 rationalises the approach as follows (using then on-current
assets figures to illustrate)
In he rent in the recognition of an asset is that the carrying amount (N1,000)
will be recovered in the form of economic benefits that will flow to the entity
in future periods.
When the carrying amount exceeds the tax base (as it does in this case at
N800) the amount of taxable economic benefit will exceed the amount that
will be allowed as a deduction for tax purposes.
This difference is a taxable temporary difference and the obligation to
pay the resulting in come tax in the future periods is a liability that exists
at the reporting date.
The company will only be able to expense N800 in the tax computations
against the recovery of N1,000.
The N200 that is not covered will be taxed and that tax should be
recognised for now.

Financial reporting
Definition: Deferred tax liability

Deferred tax liabilities are the amounts of income taxes payable in future periods
in respect of taxable temporary differences.
Deductible temporary differences

A deductible temporary difference is caused by a credit in the carrying amount of
an asset or liability in the financial statements compared to the tax base of that
item.
Deductible temporary differences lead to the recognition of deferred tax assets.
Example: Deductible temporary differences

Each of the following is a deductible temporary difference leading to the
recognition of a deferred tax asset.
Deferred
Carrying Temporary tax asset
amount Tax base difference (30%)
Non-current asset (note 1) 1,000 1,200 (200) 60
Receivable 800 900 (100) 30
Payable (1,200) (1,000) (200) 60
Note 1:
for
N financial
balance of 200 compared to the tax base. This leads to a deferred
tax asset.
Definition: Deferred tax asset

Deferred tax assets are the amounts of income taxes recoverable in future
periods in respect of:
(a) deductible temporary differences;
(b) the carry forward of unused tax losses; and
(c) the carry forward of unused tax credits.

3.3 Accounting for deferred tax

Accounting for deferred taxation involves the recognition of a liability (or an asset)
in the statement of financial position at each year end. The business must then
account for the movement on the liability.
The other side of the entry that changes the balance on the deferred taxation
liability (asset) is recognised in the statement of profit or loss. (Note, that some
differences require double entry to other comprehensive income or directly to
equity but the deferred tax consequences of these is outside your syllabus).
Approach
The calculation of the balance to be recognised in the statement of financial
position is quite straight forward.
‰ Step 1: Identify the temporary differences (this should always involve a
column are working as in the example below);
‰ Step 2: Multiply the temporary differences by the appropriate tax rate.
‰ Step 3: Compare this figure to the opening figure and complete the double
entry.
Example: Accounting for deferred tax

X plc has non-current assets with a carrying value of N200,000 and at a x base of
N140,000.
It has recognised a receivable of NI0,000. This relates to income which is taxed on
cash basis.
It has also accrued for an expense in the amount of N20,000. Tax relief is only
given on this expense when it is paid.
At the start of the year X plc had a deferred tax liabilityof N12,000.
Required
Show the movement on the deferred tax account and construct the journal to
record this movement.
In order to answer a question like this you need to complete the following
proforma:
N
Deferred taxation balance at the start of the year 12,000
Transfer to the income statement (as a balancing figure) ?
Deferred taxation balance at the end of the year (working) ?
In order to complete this you need a working to identify the

temporary differences.

Financial reporting
Example continued: Accounting for deferred tax

The temporary differences are identified and the required deferred tax balance
calculated as follows:
Carrying Temporary DT balance at

amount Tax base differences 30%
N N N N
Non-current assets 200,000 140,000 60,000 18,000
(liability)
Accrued income 10,000 – 10,000 3,000
(liability)
Accrued expense (20,000) – (20,000) (6,000)
asset
50,000 15,000
constructing the journal as follows:

N
Deferred taxation balance at the start of the year 12,000
Statement of profit or loss (as a balancing figure) 3,000
Deferred taxation balance at the end of the year 15,000
(working)
Journal: Debit Credit

Income statement (tax expense) 3,000
Deferred tax liability 3,000
3.4 Sources of temporary differences

Circumstances under which temporary differences arise include:
‰ Situations when income or expense is included in accounting profit in one
period but included in the taxable profit in a different period. Examples
include:
x items which are taxed on a cash basis but which will be accounted for
on an accrual basis; and
x situations where the accounting depreciation does not equal tax
allowable depreciation (capital allowance).
‰ Revaluation of assets where the tax authorities do not amend the tax base
when the asset is revalued.

Examples leading to the recognition of deferred tax liabilities
Interest may be received in arrears, leading to a receivable in the statement of
financial position. However, this interest may not be taxable until the cash is
received.
Example: Recognition of deferred tax liabilities

N in financial
No cash has yet been received and interest is taxed on a cash basis. The
interest receivable has a tax base of nil.
Carrying Temporary
amount Tax base difference
N N N
Interest receivable 600,000 – 600,000
Deferred tax liability @ 30% 180,000
Development costs may be capitalised and amortised (in accordance with IAS
38) but tax relief may be given for the development costs as they are paid.

N
These were capitalised in accordance with IAS 38, with an amortisation
charge of N in
Development costs are an allowable expense for tax purposes in the
period in which they are paid. The relevant tax rate is 30%.
Carrying Temporary
N N N
Development costs 305,000 – 305,000

Financial reporting
Accounting depreciation is not deductible for tax purposes in most tax regimes.
Instead, the governments allow a deduction on statutory grounds.

N
mulated for N
amount N
N
N
Carrying Temporary
N N N
Non-current asset 2,750,000 2,000,000 750,000
Examples leading to the recognition of deferred tax assets

Warranty costs may be recognised as a liability (in accordance with IAS 37) but
tax relief may be given only when the cash is spent in the future.
Example: Recognition of deferred tax assets

for
For tax purposes, the product warranty costs will not be deductible until the entity
pays any warranty claims.(Therefore the tax base is nil).
The company is very profitable and does not expect this to change. (This means
that they expect to pay tax in the future so should be able to recover the deferred
tax asset).
Carrying Temporary
N N N
Warranty provision 100,000 – 100,000
Deferred tax asset @ 30% 30,000

This time the financial statements contain a liability when compared
to the tax authority’s view of the situation. Therefore, deferred tax is
an asset.

It is possible to have a temporary difference even if there is no asset or liability. In

such cases there is a zero value for the asset (or liability). For example, research
costs may be expensed as incurred (in accordance with IAS 38) but tax relief
may be given for the costs at a later date.
Example: Recognition of deferred tax assets
These were expensed accordance with IAS 38.

Research costs are not permitted as a taxable deduction until a later
period. The relevant tax rate is 30%.
Carrying Temporary
N N N
Research costs nil 500,000 500,000
Deferred tax asset @ 30% 150,000
4 RECOGNITION AND MEASUREMENT RULES
Recognition of deferred tax liabilities

Recognition of deferred tax assets
A recognition issue – non-taxable items
Measurement of deferred tax balances
4.1 Recognition of deferred tax liabilities

A deferred tax liability must be recognised for all taxable temporary differences,
except to the extent that the deferred tax liability arises from:
‰ the initial recognition of goodwill; or
‰ the initial recognition of an asset or liability in a transaction which:
x is not a business combination; and
x at the time of the transaction, affects neither accounting profit nor
taxable profit (tax loss).
There is further guidance on the recognition of deferred tax liabilities in respect of
taxable temporary differences arising in a business combination but that is outside
the scope of your syllabus.

Comment on the exceptions: Goodwill
Goodwill usually exists only in group accounts. Groups are not taxed as such: it
is the members of a group that are the taxable entities, i.e., the parent and each
subsidiary are taxed separately. Goodwill in group accounts is not an asset
recognised by the tax authorities so has a tax base of nil. This means that
goodwill is a temporary difference but does not lead to the recognition of a
deferred tax liability because of the exception.
In the year ended 31 December 20X8, A Plc acquired 80% of another company
and N in
The relevant tax rate is 30%.
Carrying Temporary
N N N
Goodwill 100,000 nil 100,000
Deferred tax (due to the nil

exception)
The exception refers to the initial recognition of good will. However,
there is no deferred tax in respect of this difference at any time in the
future even.
ifthecarryingamount(andhencethetemporarydifference)changes.
In some jurisdictions goodwill can arise in individual company financial

statements. Furthermore, the goodwill might be tax deductible in those
jurisdictions. In such cases goodwill is just the same as any other asset and its
tax consequences would be recognised in the same way.
In the year ended 31 December 20X8, B Plc acquired a partnership and

recognised N in this
Carrying Temporary
N N N
Goodwill 100,000 100,000 nil
Deferred tax on initial recognition nil
In the future, both the carrying amount and the tax base of the
goodwill might change leading to deferred tax consequences.
Comment on the exceptions: Initial recognition of other items

A temporary difference may arise on initial recognition of an asset or liability, for
example if part or all of the cost of an asset will not be deductible for tax purposes.
This exception relates to the initial recognition of an asset or liability in a
transaction that is not a business combination. In other words, the exception does
not apply if the initial recognition is due to a business combination. There is
guidance on deferred tax arising in business combinations, but this is not
examinable at this level.

If the transaction is not a business combination and effects either accounting
profit or taxable profit the exception does not apply and deferred tax is
recognised on initial recognition.
N
N in
N in
Under the tax rules in C Plc’s jurisdiction the cost of arranging the loan is
deductible in the period in which the loan is made.
Carrying Temporary
N N N
Goodwill 105,000 100,000 5,000
Deferred tax on initial 1,500

recognition
The exception does not apply as the transaction affects the

taxable profits on initial recognition.
If the transaction is not a business combination, and affects neither accounting

profit nor taxable profit, deferred tax would normally be recognised but the
exception prohibits it.
Example: Initial recognition

In the year ended 31 December 20X8, D Plc acquired a non-current asset at a
cost of N100,000. The asset is to be depreciated on a straightline basis over its
useful life of 5 years.
The asset falls outside the tax system. Depreciation is not allowable for tax
purposes and there is no tax deductible equivalent. Any gain on disposal is not
taxable and any loss on disposal not taxable.
Initial recognition:
Carrying Temporary
N N N
Non-current asset 100,000 nil 100,000
Deferred tax on initial recognition (due to them exception) nil
Subsequent measurement (1 year later)

Carrying Temporary
amount Taxbase difference
N N N
Non-current asset 80,000 nil 80,000
Deferred tax on initial recognition (due to the exception

– this still results from the initial recognition) nil

4.2 Recognition of deferred tax assets

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, unless the deferred tax asset
arises from the initial recognition of an asset or liability in a transaction that:
‰ is not a business combination; and
‰ at the time of the transaction, affects neither accounting profit nor taxable
profit (taxloss).
There is further guidance on the recognition of deferred tax asset in respect of
deductible temporary differences arising in a business combination but that is
outside the scope of your syllabus.
A deferred tax asset must only be recognised to the extent that it is probable that
taxable profit will be available against which the deductible temporary difference
can be used.
This means that IAS 12 brings a different standard to the recognition of deferred
tax assets than it does to deferred tax liabilities:
‰ liabilities are always be recognised in full (subject to certain exemptions
beyond the scope of your syllabus); but
‰ assets may not be recognised in full (or in some cases at all).
IAS 12 also requires that the carrying amount of a deferred tax asset must be
reviewed at the end of each reporting period to check if it is still probable that
sufficient taxable profit is expected to be available to allow the benefit of its use.
If this is not the case the carrying amount of the deferred tax asset must be
reduced to the amount that it is expected will be used in the future. Any such
reduction might be reversed in the future if circumstances change again.
4.3 A recognition issue–non-taxable items

The definition of temporary difference is repeated here for convenience:
Definition: Temporary difference

Temporary differences are differences between the carrying amount of an asset
or liability in the statement of financial position and its tax base.
Deferred tax should be recognised only in respect of those items where expense
or income is recognised in both accounting profit and taxable profit but in different
periods.

Unfortunately, applying the definition of temporary difference given above would
result in the inclusion of items where the difference might not be temporary but
permanent in nature.
Example: Permanent difference.

N in for
the year.
This income is not taxable.
Applying the definition of temporary difference would lead to the following:
Carrying Temporary
N N N
100,000 nil 100,000
Receivable
However, this is not a temporary difference. It is not a transaction

recognised in accounting profits in one period and taxable profits
in another.
It is never recognised in taxable profits.
Items not taxable or tax allowable should not result in the recognition of deferred
tax balances. In order to achieve this effect, IAS 12 includes the following rules:
‰ 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.
‰ 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.
Returning to the above example:
Example: Permanent difference.

in for
the year.
This income is not taxable.
Applying the definition of temporary difference would lead to the following:
Carrying Temporary
N N N
100,000 100,000 nil
Receivable
The item is not taxables its tax baseis set to be the same as its
carrying amount.
This results in a nil temporary difference and prevents the recognition of
deferred tax on this asset.
This sound rather complicated but just remember that it is a mechanism to

exclude non-taxable items from the consideration of deferred tax (even though
the definition might have included them).
Remember this: there is no deferred tax to recognise on items that are not
taxed or for which no tax relief is given.
Closing comment
Accounting for deferred taxation restores the relationship that should exist
between the profit before tax in the financial statements, the tax rate and the tax
charge. In earlier examples we saw that after accounting for deferred tax the tax
expense (current and deferred tax) was equal to the tax rate u the accounting
profit before tax.
This will not be the case if there are permanent differences.
4.4 Measurement of deferred taxbalances

Deferred tax assets and liabilities must not be discounted.
Deferred tax assets and liabilities must 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.
5 PRESENTATION AND DISCLOSURE
Presentation
Disclosure
5.1 Presentation
IAS 12: Income taxes contains rules on when current tax liabilities may be offset
against current tax assets
Offset of current tax liabilities and assets

A company must offset current tax assets and current tax liabilities if, and only if,
it:
‰ has a legally enforceable right to set off the recognised amounts; and
‰ intends either to settle on a net basis, or to realise the asset and settle the
liability simultaneously.
These are the same rules as apply to assets and liabilities in general as
described in IAS 1.
In the context of taxation balances whether a current tax liability and asset may
be offset is usually specified in tax law, thus satisfying the first criterion.
In most cases, where offset is legally available the asset would then be settled on
a net basis (i.e., the company would pay the net amount).
Offset of deferred tax liabilities and assets

A company must offset deferred tax assets and deferred tax liabilities if, and only
if:
‰ the entity has a legally enforceable right to set off current tax assets against
current tax liabilities; and
‰ the deferred tax assets and the deferred tax liabilities relate to income
taxes levied by the same taxation authority on either:
x the same taxable entity; or
x different taxable entities which intend either to settle current tax
liabilities and assets on a net basis, or to realise the assets and settle
the liabilities simultaneously, in each future period in which significant
amounts of deferred tax liabilities or assets are expected to be settled
or recovered.
The existence of deferred tax liability is strong evidence that a deferred tax asset
from the same tax authority will be recoverable.
Example: Offset of deferred tax liabilities and assets

The following deferred tax positions relate to
thesameentity: Situation 1 Situation 2
Deferred tax liability 12,000 5,000
Deferred tax asset (8,000) (8,000)
4,000 (3,000)
In situation 1, the financial statements will report the net position as a liability of
4,000. The existence of the liability indicates that the company will be able to
recover the asset, so the asset can be set off against the liability.
In situation 2, setting off the asset against the liability leaves a deferred tax asset
of 3,000. This asset may only be recognized if the entity believes it is probable
that it will be recovered in the foreseeable future.
5.2 Disclosure
This section does not include the IAS 12 disclosure requirements in respect of
those aspects of deferred taxation which are not examinable at this level.
Components of tax expense (income)

The major components of tax expense (income) must be disclosed separately.
Components of tax expense (income) may include:
current tax expense(income);
‰ any adjustments recognised in the period for current tax of prior periods;
‰ the amount of deferred tax expense (income) relating to the origination and
reversal of temporary differences;
‰ the amount of deferred tax expense (income) relating to changes in tax rates
or the imposition of new taxes;
‰ the amount of the benefit arising from a previously unrecognised tax loss, tax
credit or temporary difference of a prior period that is used to reduce current tax
expense;
‰ deferred tax expense arising from the write-down, or reversal of a previous write-
down, of a deferred tax asset;
‰ the amount of tax expense (income) relating to those changes in
accounting policies and errors that are included in profit or loss in
accordance with IAS 8, because they cannot be accounted for
retrospectively.

Illustration: Note to the statement of profit or loss
Taxation expense N
Current tax 129,000
Adjustment for over estimate of tax in prior year (5,000)
Deferred taxation
Arising during the period 20,000
Due to change in tax rate (5,000)
15,000
139,000
Example: Change in rate

31 December 20X8 Profits
were taxed at 30%.
N
N 000).
31 December 20X9
The tax rate changed to 25% during the year.
At the year- end A Plc carried out the following deferred tax calculation:
Carrying Temporary
N N N
Non-current assets 1,000,000 820,000 180,000
Deferred tax at 25% 45,000
Statement of profit or loss: Rate change (5/30 u30,000) (5,000)

Deferred taxation b/f restated
Statement of profit or loss (balancing figure – due to the
origination of temporary differences in the period)
Deferred taxation balance at the end of the year (working)
Journal: Debit Credit

Deferred tax liability 15,000

Tax reconciliation
The following must also be disclosed:
‰ an explanation of the relationship between tax expense (income) and
accounting profit in either or both of the following forms:
x 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
x 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;
‰ an explanation of changes in the applicable tax rate(s) compared to the
previous accounting period;
A major theme in this chapter is that the different rules followed to calculate
accounting profit and taxable profit lead to distortion of the relationship that exists

Financial reporting
between profit before tax in the financial statements, the tax rate and the current
tax expense for the period. Accounting for deferred tax corrects this distortion so
that after accounting for deferred tax the tax expense (current and deferred tax)
was equal to the tax rate u the accounting profit before tax.
This is not the case if there are permanent differences. The above reconciliations
show the effect of permanent differences.
N
N not
in N
N N in
B Plc’s taxation computation is as follows: N

Add back inadmissible deductions
Depreciation 100,000
Deduct admissible deduction
Tax allowable depreciation 150,000
Income not taxed 20,000
(170,000)
Taxable profit 430,000
Tax at 30% 129,000
Tax expense N
Current tax 129,000
Deferredtaxation (30%u N50,000) 15,000
Tax expense 144,000
Tax reconciliation (in absolute numbers) N

Applicable tax rate 30%
Accounting profit u the applicable tax rate 150,000
Tax effect of untaxed income (30% of N20,000) (6,000)
Tax expense 144,000
Tax reconciliation (in percentages)

Applicable tax rate 30.0%
Tax effect of untaxed income (6,000/500,000) (1.2%)
Effective tax rate (144,000/500,000) 28.8%

Other disclosures
An entity must disclose the amount of income tax consequences of dividends to
shareholders of the entity that were proposed or declared before the financial
statements were authorised for issue, but are not recognised as a liability in the
financial statements;
An entity must disclose the amount of a deferred tax asset and the nature of the
evidence supporting its recognition, when:
‰ the utilisation of the deferred tax asset is dependent on future taxable
profits in excess of the profits arising from the reversal of existing taxable
temporary differences; and
‰ the entity has suffered a loss in either the current or preceding period in the
tax jurisdiction to which the deferred tax asset relates.

Financial reporting
Practice questions 1
XYZ Limited had an accounting profit before tax of N90,000 for the year
ended 31st December 20X8. The tax rate is 30%.
The following balances and information are relevant as at 31st December
20X8.
Non-currentassets N N
Property 63,000 1
Plant and machinery 100,000 90,000 2
Receivables:
Trade receivables 73,000 3
Interest receivable 1,000 4
Payables
Fine 10,000
Interest payable 3,300 4
Note1: The property cost the company N70,000 at the start of the year. It is
being depreciated on a 10% straight line basis for accounting purposes.
The company’s tax advisers have said that the company can claim N42,000
accelerated depreciation as a taxable expense in this year’s tax
computation.
Note2: The balances in respect of plant and machinery are after providing
for accounting depreciation of N12,000 and tax allowable depreciation of
N10,000 respectively.
Note3: The receivables figure is shown net of an allowance for doubtful
balances of N7,000. This is the first year that such an allowance has been
recognised. A deduction for debts is only allowed for tax purposes when the
debtor enters liquidation.
Note4: Interest income is taxed and interest expenseis allowable on a cash
basis. There were no opening balances on interest receivable and interest
payable.
a. Prepare a tax computation and calculate the current tax expense.

b. Calculate the deferred taxliability required as at 31December 20X8.
c. Show them ove menton the deferred tax account for the year ended
31 December 20X8 given that the opening balance was N3,600 Cr.
d. Prepare a note showing the components of the tax expense for the period.
e. Prepare a reconciliation between the tax expenseand the product of
the accounting profit multiplied by the applicable rate.

6 CHAPTER REVIEW
Account for current tax
Define temporary differences
Identify temporary differences that cause deferred tax liabilities and deferred
tax assets
Determine the amount of deferred tax to be recognised in respect of temporary
differences identified
Apply the disclosure requirements of IAS 12
Solution: Tax computation for they earended 31December 1a

20X8
N N
Add back inadmissible expenses
Depreciation on property 7,000
Depreciation of plant and machinery 12,000
Increase in provision for doubtful debts 7,000
Interest payable accrual 3,300
Fine 10,000 39,300
Less admissible deductions
Interest income 1,000
Tax allowable depreciation on property 42,000
Tax allowable depreciation on
plantand machinery 10,000 (53,000)
76,300
Tax 30% 22,890

Financial reporting
Solution: Deferred tax liability as 31 December 20X8 1b

Carrying Temporary
value Tax base difference
N N N
Property 63,000 28,000 35,000
Plant and machinery 100,000 90,000 10,000
Trade receivables 73,000 80,000 (7,000)
Interest receivable 1,000 nil 1,000
Fine (10,000) (10,000) –
Interest payable (3,300) nil (3,300)
35,700
Deferred tax @ 30% 10,710
Temporary Deferred
differences tax @ 30%
Deferred tax liabilities 46,000 13,800
Deferred tax assets (10,300) (3,090)
10,710

20X8.
N
st
Deferred tax as at 1 January 20X9 3,600
Statement of profit or loss (balancing figure) 7,110
Deferred tax as at 31stDecember 20X9 10,710
Solution: Components of tax expense for they earended 31December 20X8. 1d

N
Current tax expense (see part a) 22,890
Deferred tax (see part c) 7,110
Tax expense 30,000
1e
N
Accounting profit
Tax at the applicable rate (30%)
Tax effects of expenses that are not deductible in determining
taxable profit
Fines 3,000
Tax expense 30,000

Skills level
R
E
T
P
A
H
C
Introduction to IFRS 13
Measurement
Valuation techniques
Disclosure
Chapter review

Financial reporting
INTRODUCTION
Aim
principles.
Detailed syllabus
statements
a Differentiate between debt and equity financial instruments.
b Calculate, where necessary, discuss and account for fair value
measurement of financial assets and liabilities in accordance with the
provisions of relevant accounting standards (IAS 32, IFRS 7 and IFRS 9
and IFRS 13) with respect to measurement, recognition, de-recognition and
disclosures, excluding hedging but including simple impairment cases.
Exam context
This chapter explains rules on measuring fair value.

„ Define fairvalue
„ Measure fair value in situations involving a principal or most advantageous market and
situations involving the highest and best use of assets
„ Explain different techniques that might be used to arrive at fair value
„ Describe the fair value hierarchy set out in the standard

Chapter 15: IFRS 13: Fair Value Measurement
1 INTRODUCTION TO IFRS13
Section overview
„ Background
„ Definition of fair value
„ The asset or liability
„ Market participants
1.1 Background
There are many instances where IFRS requires or allows entities to measure or
disclose the fair value of assets, liabilities or their own equity instruments.
Examples include (but are not limited to):
IASs16/38 Allows the use of a revaluation model for the measurement of
assets afterrecognition.
Under this model, the carrying amount of the asset is based
on its fair value at the date of the revaluation.
IAS40 Allows the use of a fair value model for the measurement of
Under this model, the asset is fair valued at each reporting
date.
IFRS9 All financial instruments are measured at their fair value at
initialrecognition.
Financial assets that meet certain conditions are measured at
amortised cost subsequently. Any financial asset that does not
meet the conditions is measured at fair value.
Subsequent measurement of financial liabilities is sometimes
at fair value.
IFRS7 If a financial instrument is not measured at fair value that
amount must be disclosed.
IFRS3 Measuring goodwill requires the measurement of the
acquisition date fair value of consideration paid and the
measurement of the fair value (with some exceptions) of the
assets acquired and liabilities assumed in a transaction in
which control is achieved.
Other standards require the use of measures which incorporate fair value.
IASs36 Recoverable amount is the lower of value in use and fair
value less costs ofdisposal.
IFRS5 An asset held for sale is measured at the lower of its carrying
amount and fair value less costs of disposal.
Some of these standards contained little guidance on the meaning of fair value.
Others did contain guidance but this was developed over many years and in a
piecemeal manner.

Financial reporting
Purpose of IFRS 13
The purpose of IFRS 13 is to:
‰ define fairvalue;
‰ set out a single framework for measuring fair value; and
‰ specify disclosures about fair value measurement.
IFRS 13 does not change what should be fair valued nor when this should occur.
The fair value measurement framework described in this IFRS applies to both
initial and subsequent measurement if fair value is required or permitted by other
IFRSs.
Scope of IFRS 13
IFRS 13 applies to any situation where IFRS requires or permits fair value
measurements or disclosures about fair value measurements (and other
measurements based on fair value such as fair value less costs to sell) with the
following exceptions.
IFRS 13 does not apply to:
‰ share based payment transactions within the scope of IFRS 2; or
‰ measurements such as net realisable value (IAS 2 Inventories) or value in
use (IAS 36 Impairment of Assets) which have some similarities to fair
value but are not fairvalue.
The IFRS 13 disclosure requirements do not apply to the following:
‰ plan assets measured at fair value (IAS 19: Employee benefits);
‰ retirement benefit plan investments measured at fair value (IAS 26:
Accounting and reporting by retirement benefit plans); and
‰ assets for which recoverable amount is fair value less costs of disposal in
accordance with IAS36.

1.2 Definition of fairvalue
Definition: Fair value

Fair value is the price that would be received to sell an asset or paid to transfer
measurement date (i.e.it is an exit price).
This definition emphasises that fair value is a market-based measurement, not an

entity-specific measurement. In other words, if two entities hold identical assets
these assets (all other things being equal) should have the same fair value and this
is not affected by how each entity uses the asset or how each entity intends to use
the asset in the future.
The definition is phrased in terms of assets and liabilities because they are the
primary focus of accounting measurement. However, the guidance in IFRS 13
also applies to an entity’s own equity instruments measured at fair value (e.g.,
when an interest in another company is acquired in a share for share exchange).
Note that the fair value is an exit price, i.e., the price at which an asset would be
sold.
Definition: Exit and entry prices

Exitprice: The price that would be received to sell an asset or paid to transfer
a liability.
Entryprice: The price paid to acquire an asset or received to assume a
liabilityin an exchange transaction.
1.3 The asset or liability

A fair value measurement is for a particular asset or liability.
Whether the fairvalue guidance in IFRS 13 applies to a stand-alone asset or liability
or to a group of assets, a group of liabilities or to a group of assets and liabilities
depends on the unit of account for the item being fairvalued.
Definition: Unit of account

Unit of account: The level at which an asset or a liability is aggregated or
disaggregated in an IFRS for recognition purposes.
The unit of account for the asset or liability must be determined in accordance
with the IFRS that requires or permits the fair value measurement.
An entity must use the assumptions that market participants would use when
pricing the asset or liability under current market conditions when measuring fair
value. The fair value must take into account all characteristics that a market
participant would consider relevant to the value. These characteristics might
include:
‰ the condition and location of the asset; and
‰ restrictions, if any, on the sale or use of the asset.

Financial reporting
1.4 Market participants
Definition: Market participants

Market participants: Buyers and sellers in the principal (or most
advantageous) market for the asset or liability.
Market participants have all of the following characteristics:

‰ They are independent of each other;
‰ They are knowledgeable, having a reasonable understanding about the
asset or liability and the transaction using all available information,
including information that might be obtained through due diligence efforts
that are usual and customary.
‰ They are able to enter into a transaction for the asset or liability.
‰ They are willing to enter into a transaction for the asset or liability, i.e., they
are motivated but not forced or otherwise compelled to do so.

2 MEASUREMENT
Measuring fairvalue
Principal or most advantageous market
Fair value of non-financial assets – highest and best use
2.1 Measuring fairvalue

Fair value measurement assumes that the asset (liability) is exchanged in an
orderly transaction between market participants to sell the asset (transfer the
liability) at the measurement date under current market conditions.
Sometimes it might be possible to use observable market transactions to fair
value an asset or a liability (e.g. a share might be quoted on the Karachi Stock
Exchange). For other assets and liabilities this may not be possible. However, in
each case the objective is the same, being to estimate the price at which an
orderly transaction to sell the asset (or transfer a liability) would take place
between market participants at the measurement date under current market
conditions.
Active market
If an active market exists then it will provide information that can be used for fair
value measurement.
‰ A quoted price in an active market provides the most reliable evidence of
fair value and must be used to measure fair value whenever available.
‰ It would be unusual to find an active market for the sale of non- financial
assets so some other sort of valuation technique would usually be used to
determine their fairvalue.
Definition: 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.
If there is no such active market (e.g., for the sale of an unquoted business
or surplus machinery) then a valuation technique would be necessary.

Financial reporting
2.2 Principal or most advantageous market

Fair value measurement is based on a possible transaction to sell the asset or
transfer the liability in the principal market for the asset or liability.
If there is no principal market fair vale measurement is based on the price
available in the most advantageous market for the asset or liability.
Definitions: Most advantageous market and principal market

Most advantageous market: The market that maximizes the amount that would
be received to sell the asset or minimises the amount that would be paid to
transfer the liability, after taking into account transaction costs and transport
costs.
Principal market: The market with the greatest volume and level of activity for
the asset or liability.
Identifying principal market (or most advantageous market)

It is not necessary for an entity to make an exhaustive search to identify the
principal market (or failing that, the most advantageous market). However, it
should take into account all information that is reasonably available.
Unless there is evidence to the contrary, principal market (or failing that, the most
advantageous market) is the one in which an entity normally enters into
transactions sell the asset or to transfer the liability being fair valued.
If there is a principal market for the asset or liability, the fair value measurement
must use the price in that market even if a price in a different market is potentially
more advantageous at the measurement date.
The price in a principal market might either be directly observable or estimated
using a valuation technique.
Transaction costs
The price in the principal (or most advantageous) market used to measure the
fair value of the asset (liability) is not adjusted for transaction costs. Note that:
‰ fair value is not “net realisable value” or “fair value less costs of disposal”;
and
‰ using the price at which an asset can be sold for as the basis for fair
valuation does not mean that the entity intends to sell it
Transport costs
If location is a characteristic of the asset the price in the principal (or most
advantageous) market is adjusted for the costs that would be incurred to
transport the asset from its current location to that market.

Example: Fair valuation

An entity holds an asset which could be sold in one of two markets.
Information about these markets and the costs that would be incurred if a sale
were to be made is as follows:
Market A Market B
N N
Sale price 650 625
Transport cost (50) (50)
600 575
Transaction cost (75) (25)
Net amount received 525 550
Fair value of the asset if Market A were the principal market

If Market A is the principal market for the asset the fair value of the asset
would be measured using the price that would be received in that
market,after taking in to account transport costs (N600).
Fair value of the asset if no principal market could be identified

If neither market is the principal market for the asset, the fair value of the
asset would be measured using the price in the most advantageous market.
The most advantageous market is the market that maximizes the amount that
would be received to sell the asset, after taking into account transaction costs
and transport costs (i.e., the net amount that would be received in the
respective markets). This is Market B where the net amount that would be
received for the asset would be N550.
The fairvalue of the asset is measured using the price in that market (N625),
less transport costs (N50), resulting in a fairvalue measurement of N575.
Transaction costs are taken into account when determining which market is
the most advantageous market but the price used to measure the fairvalue of
the asset is not adjusted for those costs (although it is adjusted for transport
costs).

Financial reporting
Example: Fair valuation

An entity owns an item of industrial equipment (asset x) for which it wishes to
ascertain a fair value in accordance with IFRS 13.
Information about the markets in which the asset could be sold and the costs
that would be incurred if a sale were to be made is as follows:
Market A Market B
N N
Sale price 500 505
Transport cost (20) (30)
480 475
Volume of sales of asset x (units) 1,000 29,000
Most advantageous market

Market A is the most advantageous market as it provides the highest return
after transaction costs.
Fair value of the asset in accordance with IFRS 13
in N price
available in the principal market before transaction costs. (The principal
market is the one with the highest level of activity).
Different entities might have access to different markets. This might result in
different entities reporting similar assets at different fair values.
2.3 Fair value of non-financial assets–highest and best use

Fair value measurement of a non-financial asset must value the asset at its
highest and best use.
Highest and best use is a valuation concept based on the idea that market
participants would seek to maximise the value of an asset.
Definition: Highest and best use

Highest and best use: The use of an on-financial asset by market participants
that would maximise the value of the asset or the group of assets and
liabilities(e.g.a business)within which the asset would be used.
This must take into account use of the asset that is:
‰ Physically possible;
‰ legally permissible; and
‰ financially feasible.
The current use of land is presumed to be its highest and best use unless market
or other factors suggest a different use.

Example: Highest and best use

X Limited acquired a plot of land developed for industrial use as a factory. A
for N
Similar sites near by have recently been developed for residential use as sites
for high-rise apartment buildings.
X Limited determines that the land could be developed as a site for residential
N lion demolition facto
N
million.
The highest and best use of the land would be determined by comparing the
following:
N
Value of the land as currently developed
N N
N
3 VALUATION TECHNIQUES
Objective of valuation techniques

Inputs to valuation techniques
Fair value hierarchy
Bid/offer prices
3.1 Objective of valuation techniques

The objective of using a valuation technique is to estimate the price at which an
orderly transaction to sell the asset (or to transfer the liability) would take place
between market participants at the measurement date under current market
conditions.
IFRS 13 requires that one of three valuation techniques must be used:
‰ market approach – uses prices and other relevant information from market
transactions involving identical or similar assets and liabilities;
‰ cost approach – the amount required to replace the service capacity of an
asset (also known as the current replacementcost);
‰ income approach – converts future amounts (cash flows, profits) to a single
current (discounted) amount.
An entity must use a valuation technique that is appropriate in the circumstances
and for which sufficient data is available to measure fair value, maximising the use
of relevant observable inputs and minimising the use of unobservable inputs.

3.2 Inputs to valuation techniques
An entity must use valuation techniques that are appropriate in the circumstances
and for which sufficient information is available to measure fair value.
A valuation technique should be used to maximise the use of relevant observable
inputs and minimise the use of unobservable inputs.
Definition: Inputs
Inputs: The assumptions that market participants would use when pricing the
asset or liability, including assumptions about risk, such as the following:
(a) the risk inherent in a particular valuation technique used to measure fair
value (such as a pricing model);and
(b) the risk inherent in the inputs to the valuation technique.
Quoted price in an active market provides the most reliable evidence of fair value
and must be used to measure fair value whenever available.
3.3 Fair value hierarchy

IFRS 13 establishes a fair value hierarchy to categorise inputs to valuation
techniques into three levels.
Definition Examples
Level1 Quoted prices inactive Share price quoted on the Nigerian
markets for identical Stock Exchange
assets or liabilities that the
entity can access at the
measurement date
Level2 Inputs other thanquoted Quoted price of a similar asset to
prices included within the one being valued.
Level 1 that are Quoted interest rate.
observable for the asset or
liability, either directly or
indirectly.
Level3 Unobservable inputsfor Cash flow projections.
the asset or liability.
3.4 Bid /Offerprices
For some assets (liabilities) markets quote prices that differ depending on
whether the asset is being sold to or bought from the market.
‰ The price at which an asset can be sold to the market is called the bid price
(it is the amount the market bids for the asset).
‰ The price at which an asset can be bought from the market is called the ask
or offer price (it is the amount the market asks for the asset or offers to sell it
for).
The price within the bid-ask spread that is most representative of fair value in the
circumstances must be used to measure fair value.
Previously, bid price had to be used for financial assets and ask price for financial
liabilities but this is no longer the case.

Financial reporting
4 DISCLOSURE
Recurring and non-recurring fair value measurement

Overall disclosure objective
Specific disclosures
4.1 Recurring and non-recurring fair value measurement

The fair value measurement of assets and liabilities might be recurring or non-
recurring.
‰ Recurring fair value measurements are those that are required or permitted
in the statement of financial position at the end of each reporting period (e.g.,
the fair value of investment property when the IAS 40 fair value model
isused);
‰ Non-recurring fair value measurements are those that are required or
permitted in the statement of financial position in particular circumstances
(e.g., when an entity measures an asset held for sale at fair value less costs
to sell in accordance with IFRS 5).
Disclosures are necessary in respect of each of the above.
4.2 Overall disclosure objective

Information must be disclosed to help users assess both of the following:
• the valuation techniques and inputs used to measure the fair value assets
and liabilities on a recurring or non-recurring basis;
• the effect on profit or loss or other comprehensive income for the period of
recurring fair value measurements using significant unobservable inputs
(Level3).
All of the following must be considered to meet the above objectives:
• the level of detail necessary to satisfy the disclosure requirements;
• how much emphasis to place on each of the various requirements;
• how much aggregation or disaggregation to undertake; and
• the need for additional information.
Classes of assets and liabilities

Classes of assets and liabilities must be identified for the purpose of fulfilling the
minimum disclosure requirements of IFRS 15.
Appropriate classes are identified on the basis of the following:
‰ the nature, characteristics and risks of the asset or liability; and
‰ the level of the fair value hierarchy within which the fair value measurement
is categorised.

4.3 Specific disclosures

The following information must be disclosed as a minimum for each class of
assets and liabilities measured at fair value in the statement of financial position
after initial recognition.
For recurring and non-recurring fair value measurements

The fair value measurement at the end of the reporting period and the reasons
for the measurement for non-recurring fair value measurements
The level of the fair value hierarchy within which the fair value measurements are
categorised in their entirety (Level 1, 2 or 3).
For fair value measurements categorised within Level 2 and Level 3 of the fair
value hierarchy:
‰ a description of the valuation technique(s) and the inputs used in the fair
value measurement for;
‰ the reason for any change in valuation technique;
Quantitative information about the significant unobservable inputs used in the fair
value measurement for fair value measurements categorised within Level 3 of the
fair value hierarchy.
A description of the valuation processes used for fair value measurements
categorised within Level 3 of the fair value hierarchy.
The reason why a non-financial asset is being used in a manner that differs from
its highest and best use when this is the case.
For recurring fair value measurements

The amounts of any transfers between Level 1 and Level 2 of the fair value
hierarchy, the reasons for those transfers and the entity’s policy for determining
when transfers between levels are deemed to have occurred.
For fair value measurements categorised within Level 3 of the fair value
hierarchy:
‰ a reconciliation of opening balances to closing balances, disclosing
separately changes during the period attributable to thefollowing:
x total gains or losses recognised in profit or loss (and the line items in
which they arerecognised);
x unrealised amounts included in the above;
x total gains or losses recognised in other comprehensive income
(and the line item in which they arerecognised);
x purchases, sales, issues and settlements;
x details of transfers into or out of Level 3 of the fair value hierarchy;
‰ for recurring fair value measurements categorised within Level 3 of the fair
valuehierarchy:
x a narrative description of the sensitivity of the fair value measurement
to changes in unobservable inputs;
x the fact that a change to one or more of the unobservable inputs
would change fair value significantly (if that is the case) and the effect
of those changes.

Financial reporting
Other
If financial assets and financial liabilities are managed on a net basis and the fair
value of the net position is measured that fact must be disclosed.
5 CHAPTER REVIEW
Define fairvalue
Measure fair value in situations involving a principal or most advantageous
market and situations involving the highest and best use of assets
Explain different techniques that might be used to arrive at fairvalue
Describe the fair value hierarchy set out in the standard

Skills level
R
E
T
P
A
H
C
GAAP for financial instruments

Measurement methods
Classification and measurement of financial assets
Classification and measurement of financial liabilities
Impairment of financial assets
Chapter review

Financial reporting
INTRODUCTION
Aim
principles.
Detailed syllabus
statements
provisions of relevant accounting standards (IAS 32, IFRS 7 and IFRS 9
and IFRS 13) with respect to measurement, recognition, de-recognition and
IFRS 9 is an examinable document.
Exam context
This chapter explains the basic rules on the recognition and measurement of financial
instruments.

„ Define financial asset and financial liability
„ Explain fair value and amortised cost
„ Apply the correct accounting treatment for the different categories of financial asset
identified by IFRS 9
„ Account for financial liabilities in accordance with IFRS 9
„ Account for simple impairment under IFRS 9

Chapter 16: IFRS 9: Financial instruments: Recognition and measurement
1 GAAP FOR FINANCIAL INSTRUMENTS
Section overview
„ Background
„ Definitions
„ Initial recognition and measurement of financial instruments
„ Derecognition
1.1 Background
The rules on financial instruments are set out in three accounting standards:
‰ IAS 32: Financial instruments: Presentation
‰ IFRS 7: Financial instruments: Disclosure
‰ IFRS 9: Financial Instruments
1.2 Definitions
A financial instrument is a contract that gives rise to both:
‰ a financial asset in one entity, and
‰ a financial liability or equity instrument in another entity.
A financial asset is any asset that is:

‰ cash;
‰ an equity instrument of another entity;
‰ a contractual right:
x to receive cash or another financial asset from another entity; or
x to exchange financial assets or financial liabilities with another entity
A financial liability is any liability that is a contractual obligation:

‰ to deliver cash or another financial asset to another entity; or
‰ to exchange financial assets or financial liabilities with another entity under
conditions that are potentially unfavourable to the entity.
Financial instruments include:

‰ cash;
‰ shares;
‰ loans; and
‰ accounts receivable or accounts payable.

Financial reporting
1.3 Initial recognition and measurement of financial instruments

A financial asset or a financial liability should be recognised in the statement of
financial position when the reporting entity becomes a party to the contractual
provisions of the instrument.
This is different from the normal recognition criteria for an asset or a liability
described in the IASB’s Conceptual Framework which states that an item should
be recognised when there is a probable inflow or outflow of economic benefits.
Initial measurement
A financial instrument should initially be measured at fair value. This is usually
the transaction price, in other words, the price paid for an asset or the price
received for a liability.
Despite the above, trade receivables are measured at their transaction price in
accordance with IFRS 15: Revenue from contracts with customers.
If the transaction price differs from the fair value a gain or loss would be
recognised on initial recognition.
Example: Initial measurement

A company lends N1million at 0% repayable in12months.
A market based interest rate for such a loan is 10% and a 1 year discount rate
would be 1/1.1 = 0.909
The fair value of the loan on initial recognition= N1mu0.909090 = N909,091.
The double entry on initial recognition should be:
Dr Financial asset N909,091
Dr PorL(loss) N90,909
Cr Cash N1,000,000
Transaction costs
When a financial instrument is acquired, there will usually be transaction costs
incurred in addition to the transaction price. For example, transaction costs may
include a broker’s fees.
Definition: Transaction costs

Transaction costs are incremental costs that are directly attributable to the
acquisition, issue or disposal of a financial asset or financial liability.
An incremental cost is one that would not have been incurred if the entity had
not acquired, issued or disposed of the financial instrument.

The accounting treatment for transaction costs depends on how the instrument is
subsequently measured.
Subsequent measurement Treatment of transaction cost

Fair value through profit or loss Written off as an expense in profit and loss.
Other methods (Amortised cost The transaction cost is capitalised and
or fair value through OCI) included in the initial cost of the financial
instrument.
There is an example to show this in a later section of this chapter.
Note that trade receivables that do not have a significant financing component
must be measured at their transaction price on initial recognition.
1.4 Derecognition
Derecognition is the removal of a previously recognised financial asset or
financial liability from an entity’s statement of financial position.
Derecognition of a financial liability

A financial liability (or a part of a financial liability) is derecognised when, and only
when, it is extinguished.
This is when the obligation specified in the contract is discharged or cancelled or
expires.
Derecognition of a financial asset

Most transactions involving derecognition of a financial asset are straightforward.
However, financial assets may be subject to complicated transactions where some
of the risks and rewards that attach to an asset are retained but some are passed
on. IFRS 9 contains complex guidance designed to meet the challenge posed by
complex transactions.
The guidance is structured so that a transaction involving a financial asset is
subject to a series of tests to establish whether the asset should be
derecognised. These tests can be framed as a series of questions.
1 Have the contractual rights to cash flows of the financial asset expired?
x If the answer is “yes” – derecognise the financial asset
x If the answer is “no” – ask the next question
2 Has the asset been transferred to another party?
x If the answer is “no” – the asset is retained (not derecognised)
x If the answer is “yes” – ask the next question
3 Have substantially all of the risks and rewards of ownership passed?
x If the answer is “the risks and rewards are neither passed nor
retained (i.e., some are passed but some kept)” – ask the next
question

4 Has the asset been transferred in a way such that risks and rewards of
ownership have neither passed nor been retained but control has been lost
This all sounds very complicated but what it means is that a financial asset is
derecognised if one of three combinations of circumstances occur:
‰ The contractual rights to the cash flows from the financial asset expire; or
‰ The financial asset is transferred and substantially all of the risks and
rewards of ownership pass to the transferee; or
‰ The financial asset is transferred, substantially all of the risks and rewards
of ownership are neither transferred nor retained but control of the asset
has been lost.
Most transactions being considered involve the receipt of cash.
‰ Transactions where the asset is derecognised may lead to the recognition
of a profit or loss on disposal.
‰ Transactions where the asset is not derecognised lead to the recognition of
a liability for the cash received.
Example: Derecognition (I)

N tha
1 Have the contractual rights to cashflows of the financial asset

expired? Yes – Derecognise the asset
Dr Cash
N
Cr N
Example: Derecognition (II)

N
N for
without
N will be paid by the factor 30 days after the receivables are factored.
Have the contractual rights to cash flows of the financial asset expired?
No – ask the next question
Has the asset been transferred to another party? Yes (for 80% ofit)
Have substantially all of the risks and rewards of ownership passed?
The receivables are factored without recourses of ABC as passed on the risks
and rewards of ownership.
ABC must derecognise the asset transferred.
N
N
Inaddition ABC has given part of the receivable to the factor as a fee: Dr P or
N
Cr
N

Example: Derecognition (III)

ABC sells N100,000 of its accounts receivables to a factor and receives an 80%
advance immediately. The factor charges a fee of N8,000 for the service.
The debts are factored with recourse and a further advance of 12% will be
received by the seller if the customer pays on time.
Analysis
1 Have the contractuall rights to cash flows of the financial asset
expired? No – ask the next question
2 Has the asset been transferred to another
party? Yes (for 80% of it)
3 Have substantially all of the risks and rewards of owner ship passed?
The debtis factored with recourses of the bad debt risk stays with ABC.In
addition, ABC as access to future rewards as further sums are receivable
if the customers pay on time.
As ABC as kept the future risks and rewards relating to the N80,000, this
element of the receivable is not derecognised.
Dr Cash N80,000
Cr Liability N80,000
Being receipt of cash from factor–This liability is reduced as the factor
collects thecash.
Dr Liability NX
Cr Receivable NX
Inaddition ABC has given part of the receivable to the factor as a fee:
Dr PorL N8,000
Cr Receivables N8,000

Financial reporting
2 MEASUREMET METHODS
An introduction to amortised cost

Amortised cost: IFRS 9 requirements
Fair value
2.1 An introduction to amortised cost

Amortised cost is a measurement technique that can be applied to both financial
assets and financial liabilities.
The basic amortised cost technique is the same for financial assets and financial
liabilities but there is a slight difference in the terminology used by IFRS 9 when
describing the approach for each.
This section starts by explaining the basic concept of amortised cost and then
explains the slight difference in terminology between the IFRS 9 description of
amortised cost for financial assets and financial liabilities.
Basic concept
Amortised cost is calculated as follows:
Amount at initial recognition

Plus: Interest recognised at the effective rate (income for
an asset or expense for a liability):
Less: cash flows (receipts for an asset or payments for a
liability)
Amortised cost
IFRS 9 specifies that interest should be calculated using the effective rate.
The effective rate is calculated on initial recognition. It is the discount rate that
equates the future cash flows to the amount at initial recognition. In other words it
is the IRR of the cash flows associated with the financial asset or financial liability
under consideration.
The amortised cost model uses the effective rate to determine the interest to be
charged in profit and loss in each period. The interest recognised in profit and
loss each year is not the cash paid. The interest recognised is calculated by
applying the effective rate to the outstanding balance on the bond at the
beginning of the period.

Example: Amortised cost

A bond has an issue value of N1million and pays a coupon rate of 5% interest for
two years, then 7% interest for two years (this is known as a stepped bond).
Interest is paid annually on the anniversary of the bond issue. The
bond will be redeemed after four years.
The effective rate for this bond is 5.942%
The amortised cost at the end of each year over the life of the bond is as follows:
Amortised cost
brought Amortised cost
forward Interestat Cashflows carried forward
Year N 5.942% N N
1 1,000,000 59,424 (50,000) 1,009,424
2 1,009,424 59,983 (50,000) 1,019,407
3 1,019,407 60,577 (70,000) 1,009,984
4 1,009,984 60,016 (70,000) 1,000,000
240,000 240,000
The bond is initially recorded at cost (N1 million) and by the end of year 1 it as an
amortised cost of N1,009,424.
The total interest paid over the four years is N240,000. However, it is charged to
the profit or loss each year at the effective rate (5.942%) on the outstanding
balance, not as the actual interest paid on the bonds in cash each year.
The balance at the end of the bond’s life would be nil because of the repayment
of the principal. This has not been shown above to emphasise that the total
interest recognised in profit or loss and the total cash interest is the same figure
(N240,000).
Tutorial note: The following calculation proves that the IRR of the bond is
5.9423%.
Cash Discount factor Present value
Time Description flows (@5.9423%) N
N
0 Amount
1,000,000 1 1,000,000
borrowed
1 Interest (50,000) 0.94391 (47,196)
2 Interest (50,000) 0.89097 (44,548)
3 Interest (70,000) 0.84099 (58,868)
4 Interest (70,000) 0.79382 (55,567)
4 Repayment
(1,000,000)
of capital 0.79382 (793,821)
nil

Financial reporting
2.2 Amortised cost: IFRS 9 requirements

Amortised cost is used to measure financial assets and financial liabilities in the
same way. However, the terminology used in IFRS 9 is slightly different for
financial assets and financial liabilities.
This is illustrated using the amortised cost example from the last section.
As a financial liability (from the borrower’s viewpoint)

The borrower would calculate the effective rate (5.942%) and construct the
amortisation table (repeated here for your convenience) as follows:
Example: Amortised cost

Amortised cost
5.942%
N N
1 1,000,000 59,424 N
(50,000) 1,009,424
N
2 1,009,424 59,983 (50,000) 1,019,407
3 1,019,407 60,577 (70,000) 1,009,984
4 1,009,984 60,016 (1,070,000) nil
The borrower would then show the following amounts in its financial statements
at each year end:
financial position
N
1 N
59,424 1,009,424
2 59,983 1,019,407
3 60,577 1,009,984
4 60,016 nil
As a financial asset (from the lender’s viewpoint)

The lender would calculate the effective interest rate in exactly the same way and
construct the same amortisation table for its financial asset.
However, IFRS 9 defines the balances at this stage as the gross carrying amount
of the financial asset rather than amortised cost.
The only difference so far is the naming of the balances (amortised cost for
financial liabilities and gross carrying amount for financial assets).
The amortised cost of a financial asset is its gross carrying amount less a loss
allowance.
The loss allowance is a separate credit balance recognised in respect of expected
credit losses in accordance with the IFRS 9 impairment rules. These rules are
explained later but for the time being note that the final carrying amount for a
financial asset carried at amortised cost is in fact made up of two balances being
the gross carrying amount of the financial asset less the loss allowance.

(This is similar to the situation for a non-current asset which is carried at cost less
accumulated depreciation).
IFRS 9 defines the gross carrying amount of a financial asset as its amortised
cost before adjusting for any loss allowance.
The loss allowance has no impact on the calculation of the effective interest rate
or on the construction of the amortisation table. It is simply a second balance that
is deducted from the gross carrying amount to arrive at amortised cost.
The lender would show the following amounts in its financial statements at each
year end (where figures for a loss allowance have been made up):
Financial asset:
Gross Loss Net
carrying allowance (amortised
Interest income amount (say) cost)
r-end N N N N
1 59,424 1,009,424 (1,000) 1,008,424
2 59,983 1,019,407 (1,000) 1,018,407
3 60,577 1,009,984 (1,000) 1,008,984
4 60,016 nil nil
This can be summarised as follows:
Illustration: Amortised cost (financial asset compared to financial liability

Financial Financial
asset liability
N N
Amount at initial Amount at initial
recognition X recognition X
Plus: Interest Plus: Interest
recognised as income recognised as expense
at the effective rate: X at the effective rate: X
Less: receipts (X) Less: payments (X)
Gross carrying amount Amortised cost of

of financial asset X financial liability X
Less: loss allowance (X)
Amortised cost of
financial asset X
The recognition of a loss allowance results in a lower value in the books of the
lender to that in the books of the borrower for the same instrument.
If there were no loss allowance the amortised cost would be the same for the
borrower and lender of a given instrument.

Financial reporting
IFRS 9 Definitions
The IFRS 9 definitions are given below (for completeness):
Definition: 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.
Definition: Effective interest rate

The rate that exactly discounts estimated future cash receipts through the
expected life of the financial asset to the gross carrying amount of a financial
asset or the amortised cost of a financial liability.
2.3 Fairvalue

Fairvalue is the price that would be received to sell an asset or paid to transfer
measurement date (i.e. it is a next price).
Fair value measurement looks at the asset (liability) from the point of view of a
market participant. This was discussed in the previous chapter.

3 CLASSIFICATION AND MEASUREMENT OF FINANCIAL ASSETS
Introduction
Classification of financial assets
Subsequent measurement of financial assets at amortised cost
Subsequent measurement of financial assets at fair value through other
comprehensive income
Transaction costs
3.1 Introduction
Financial assets must be classified into one of three categories on initial
recognition. This classification of a financial asset drives its subsequent
measurement.
The three categories are:
‰ financial assets at amortised cost;
‰ financial assets at fair value with gains and losses recognised in other
comprehensive income (described as fair value through OCI or FVOCI); or
‰ financial assets at fair value with gains and losses recognised in profit or
loss (described as fair value through P or L or FVPL).
The classification is based on an assessment of the business model followed for

holding the financial asset and the cash flow characteristics of the asset.
This assessment is not on an asset by asset basis. Thus, an entity might hold
different portfolios for different purposes resulting in the entity using more than
one business model in turn resulting in financial assets being measured using
each of the three methods.
Reclassification
Reclassification of financial assets after initial recognition is required when an
entity changes its model for managing financial assets. It is not allowed in any
other circumstance.

Financial reporting
3.2 Classification of financial assets
Financial assets at amortised cost

A financial asset is measured at amortised cost if both of the following conditions
are met:
‰ the asset is 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 give rise on specified dates to
cash flows that are solely payments of principal and interest on the principal
amount outstanding.
Financial assets at fair value through OCI (FVOCI)

A financial asset is measured at fair value through OCI if both of the following
conditions are met:
‰ the asset is held within a business model whose objective is achieved by
both holding and collecting contractual cash flows and selling the financial
assets; and
amount outstanding.
Financial assets at fair value through P or L (FVPL)

All other financial assets must be measured at fair value through P or L.
Irrevocable designations
On initial recognition of a financial asset that would otherwise be measured at
amortised cost or at fair value through OCI a company can make an irrevocable
decision to designate them as at fair value through P or L. This is only allowed
where it eliminates or significantly reduces a measurement or recognition
inconsistency.
Investments in equity instruments are measured at fair value through P or L.
However, on initial recognition an entity is allowed to make an irrevocable
decision to measure an investment in equity at fair value with movements
reported in OCI.
Amortised cost criteria - commentary

The rules try to limit the use of amortised cost to those situations where it best
reflects the substance of the transactions. Therefore, it can only be used by a
company whose business model is to make loans and collect future repayments.
A company might sell a loan before its maturity. This does not preclude
classification of loans at amortised cost as long as the company’s overall
business model is to hold assets in order to receive contractual cash flows.
On the other hand, a company might hold a portfolio of loans in order to profit from
the sale of these assets when market conditions are favourable. In this case the
company’s business model is not to hold assets in order to receive contractual
cash flows. The loans in this portfolio must be measured at fairvalue.
The cash flows received by a company must be solely payments of the principal
lent and interest on this principal. An investment in a convertible bond would not
satisfy this criterion as a company might convert it into equity. In that case the

amounts received by the company would not solely be repayments of principal or

interest.
Overview of classification of financial assets
Method Which instruments?

Amortised cost Loans and receivables that satisfy the amortised
cost criteria
Fair value through OCI Loans and receivables that would otherwise
(FVOCI) satisfy the amortised cost criteria except that they
are traded confirm that this is correct
Equity that has been designated into this category
on initial recognition
Fair value through profit or Equity investments
loss (FVPL) Loans and receivables that fail the amortised cost
or FVOCI criteria
Loans and receivables that have been
designated into this category on initial recognition
in order to eliminate or significantly reduce a
measurement or recognition in consistency

Financial reporting
3.3 Subsequent measurement of financial assets at amortised cost

This has been covered in an earlier section.
The following example is provided as a foundation to more complex examples
later in this chapter based on the same central fact pattern but with further
complications added.
Example: Financial asset at amortised cost

X purchased a loan on 1 January 20 X 5 and classified it as measured at amortised
cost.
N
10%
Term to maturity 3years
N
Effective rate 11.67%
Required
Show the double entry for each year to maturity of the bond. (Ignore loss allowances).
An amortisation table is a useful working as a starting point and is prepared as

follows:
Amortised Interest at Cash Amortised
cost b/f 11.67% receipts costc/f
Year N N N N
20X5 48.00m 5.60m (5m) 48.60m
20X6 48.60m 5.65m (5m) 49.25m
20X7 49.25m 5.75m (55m) nil
(The amortised cost a teach date would be more correctly described as

“gross carrying amount of the financial asset”).

Example (continued): Financial asset at amortised cost

The following table summarises the above double
entries. Credit entries are shown as figures in brackets.
Financial
Cash asset P or L
Nm Nm Nm
20X5
Purchase of financial asset (48.00) 48.00
Interest accrual 5.60 (5.60)
Interest receipt 5.00 (5.00)
Amortised cost 48.60
20X6
Brought forward 48.60
49.25
20X7
Redemption 50.00 (50.00)
nil
Note that in this example the total cashflow interest received is N15m (being 3
receipts of N5m per annum).
The total interest recognised by applying the effective interest rate is N17m (being
N5.6m+N5.65m+N5.75m).
The N2m difference is the difference between the amount paid for the bond
(N48m) and the amount received on redemption (50m). The calculation of the
effective interest rate takes this into account. Interest recognised using the
effective rate includes the total interest received and the difference between the
initial outlay and redemption proceeds ifany.
In other words, the lender receives a total cash return of N17m on its investment
of N48m (being 3 receipts of N5m plus the difference between the initial
investment and the redemption proceeds). This has been recognised in the
statement of profit or loss (as N5.6m+N5.65m+N5.75m).

Financial reporting
3.4 Subsequent measurement of financial assets at fair value through

other comprehensive income
As explained earlier, a financial asset is measured at fair value through OCI if both
of the following conditions are met (unless it has been designated at FVPL):
‰ the asset is held within a business model whose objective is achieved by
both holding and collecting contractual cash flows and selling the financial
assets; and
amountoutstanding.
Only the fair value movement is recognised in other comprehensive income.
Interest income, foreign exchange gains and losses and impairment are
recognised in profit or loss.
Interest is always recognised by applying the effective rate to the amortised cost
of the bond at the start of the period. The fair value adjustment does not affect
the recognition of interest income.
The fair value adjustment in OCI will always be the accumulated difference
between the fair value and the amortised cost of the bond at the year end.
Example: Financial asset at fair value through OCI

X purchased a loan on 1 January 20X5 and classified it as measured at Fairvalue
through OCI.
Terms:
Nominalvalue N50million
Couponrate 10%
Termtomaturity 3years
Purchaseprice N48million
Effectiverate 11.67%
Fairvalues at each year end to maturity areas follows

31 December20X5 N49.2 million
Required
Show the double entry for each year to maturity of the bond. (Ignore loss allowances).

Example (continued): Financial asset at fair value through OCI

The amortisation table can be constructed in the usual way and it can be
extended to show the cumulative fair value adjustment at each reporting date.
This can then be used to calculate the annual fair value adjustment.
Interest Fair Cumulative
at Cash value fair value
AC b/f 11.67% receipt ACc/f (given) adjustment
Year Nm Nm Nm Nm Nm Nm
20X5 48.00 5.60 (5) 48.60 49.20 0.60
20X6 48.60 5.65 (5) 49.25 49.50 0.25
20X7 49.25 5.75 (55) nil nil nil
(Only the fair value adjustments are recognised in OCI. Other transactions in
respect of the financial asset (e.g. interest) are recognised in P or L in the usual
way).
The following table summarises the necessary double
entries. Credit entries are shown as figures in brackets
Financial
Cash asset OCI P or L
N Nm Nm Nm
20X5
Purchase of financial
asset (48.00) 48.00
Amortised cost 48.60
Fair value adjustment 0.60 (0.60)
49.20 (0.60)
20X6
Brought forward 49.20 (0.60)
Fair value adjustment (0.35) 0.35
49.50 (0.25)
20X7
Fair value adjustment (0.25) 0.25
nil nil
Note that the balances carried down for the financial asset are at fair value.

Financial reporting
Disposal of financial assets measured at fair value through OCI

A financial asset in this category might be sold. When this occurs, the
accumulated gain or loss previously recognised in OCI in respect of the asset is
reclassified to P or L.
(Note that this only applies to financial assets that are debt instruments. It does
not apply to those investments in equity in respect of which an entity has made
an irrevocable decision to measure at fair value through OCI).
Example: Disposal of financial asset at fair value through OCI

X purchased a loan on 1 January 20X5 and classified it as measured at
fairvalue through OCI.
The amortised cost table and the fair value adjustments in the first two years
were as follows:
Interest Fair Cumulative
at Cash value fair value
AC b/f 11.67% receipt ACc/f (given) adjustment
Year Nm Nm Nm Nm Nm Nm
20X5 48.00 5.60 (5) 48.60 49.20 0.60
20X6 48.60 5.65 (5) 49.25 49.50 0.25
for N
The journal entry to record the disposal is as
follows:
N
Cash 50
Investment 49.5
Profit or loss 0.5
AND
Other comprehensive income 0.25
Profit or loss 0.25
Notes:
N N +N0.25m).
This is the amount that would have been recognized on disposal of the asset if
it N N = N0.75m).

3.5 Transaction costs

An earlier section explained the accounting treatment of transaction costs as
follows:
Subsequent measurement Treatment of transaction cost

Fair value through profit or loss Written off as an expense in profit and
loss.
Other methods (Amortised cost of The transaction cost is capitalised and
fair value through OCI) included in the initial cost of the financial
instrument.
An earlier section explained that the price at which an asset can be sold to the
market is called the bid price and the price at which it can be bought from the
market is the offer price.
Previously, IAS 39 required that bid price had to be used for financial assets and
ask price for financial liabilities but this is no longer the case. However, a company
might have a policy of measuring the fair value of financial assets at the bid price.
This means that there would be a difference on initial recognition between the
amount paid for the asset (offer price) and the fair value of the asset using the bid
price. This difference is treated as transaction cost and accounted for following the
above rules.
for N
1January 20X6. (Equityassets must be measuredat FVPL).
N
for N
The accounting treatment for this investment is as follows:

N
N
N
N N N30,000).
11 December 20X7 The journal entry to record the disposal is as follows:
N N
DR Cash 50,000
CR Investment 40,000
CR Profit or loss 10,000

Financial reporting
N
January 20X6.
The company made an irrevocable decision to design at ethe investment as at
fair value through OCI.
N
for N
The accounting treatment for this investment is as follows:
N
capitalised transaction costs.
N
N N N30,300). N in other
comprehensive income for the year and may be accumulated in a separate
11 December 20X7
The journal entry to record the disposal is as follows:
N N
DR Cash 50,000
CR Investment 40,000
CR P or L 10,000
Amounts previously recognized in OCI in respect of equity instruments for which an

irrevocable designation has been made must not be reclassified to P or L.

4 CLASSIFICATION AND MEASUREMENT OF FINANCIAL LIABILITIES
Classification of financial liabilities

Subsequent measurement of financial liabilities at amortised cost
Summary of accounting for items measured at fairvalue
4.1 Classification of financial liabilities

All financial liabilities are classified (on initial recognition) as subsequently
measured at amortised cost with specific exceptions including:
‰ Derivatives that are liabilities at the reporting date; and
‰ Financial liabilities that might arise when a financial asset is transferred but
this transfer does not satisfy the derecognition criteria (see later in this
chapter).
Reclassification of a financial liability after initial recognition is not allowed.
Irrevocable designation
A company is allowed to designate a financial liability as measured at fair value
through profit or loss. This designation is irrevocable and can only be made if:
‰ it eliminates or significantly reduces a measurement or recognition
inconsistency; or
‰ this would allow the company to reflect a documented risk management
strategy.
Where this designation is used, the part of the change in fair value due to a change
in the entity’s own credit risk must be recognised in other comprehensive income.
This is a little difficult to understand but the rule exists to prevent an undesired
effect.

Financial reporting
Example: Changes in own credit risk

A company y issues a bond (borrows) for N1million.
The company designates the bond as measured at fair value through profit or
loss.
Situation 1
Suppose at the end of the first year the company’s credit risk had improved. This
would make the company’s debt more desirable to investors causing its fair
value to increase say to N1.1 million.
In the absence of the above rule the double entry to reflect the fair value change
would be:
DrPorL N0.1million
CrLiability N0.1million
In other words, the improvement in the company’s economic situation would
result in the recognition of an expense in its P or L account.
Situation 2
Suppose at the end of the first year the company’s credit risk had deteriorated.
This would make the company’s debt less desirable to investors causing its fair
value to decrease say to N0.9 million.
In the absence of the above rule the double entry to reflect the fair value change
would be:
DrLiability N0.1 million
Cr P or L N0.1million
In other words, the deterioration in the company’s economic situation would
result in the recognition of a gain in the P or L account.
The requirement to recognise change in fair value due to a change in the entity’s
own credit risk in other comprehensive income is an attempt to reduce the
perceived effect of the above.
4.2 Subsequent measurement of financial liabilities at amortised cost

This has been covered in an earlier section so only a basic revision is provided
here.
Amortised cost of a financial liability: The amount at which the 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.
Effective interest rate: The rate that exactly discounts estimated future cash
payments through the expected life of financial liability to the amortised cost of
a financial liability.

Example: Financial liability
X issued a loan on 1 January 20X5 and classified it as measured at amortised
cost.
N
10%
N
Required
Show the double entry for each year to maturity of the bond. (Ignore loss
allowances).
An amortisation table is a useful working as a starting point and is prepared as

follows: Amortised Interest at Cash Amortised
cost b/f 11.67% payments costc/f
Year Nm Nm Nm Nm
20X5 48.00 5.60 (5) 48.60
20X6 48.60 5.65 (5) 49.25
20X7 49.25 5.75 (55) nil
This is the same as the table from the lender’s viewpoint except the interest is
an expense rather than income and the cashflows
areoutflowsratherthaninflows.

Financial reporting
Example (continued): Financial liability

The following table summarises the necessary double
entries . Credit entries are shown as figures in brackets.
Financial
Cash liability P or L
Nm Nm Nm
20X5
Proceeds of issue 48.00 (48.00)
Interest accrual (5.60) 5.60
Interest receipt (5.00) 5.00
Amortised cost (48.60)
20X6
Brought forward (48.60)
(49.25)
20X7
Brought forward (49.25)
Redemption (50.00) 50.00
nil
Practice question
N N for
N nomi N
for N
The effective annual interest rate for this financial instrument is 7%.
Calculate the amortised cost of the bond andshow the interest income for
each year to maturity.

4.3 Summary of accounting for items measured at fairvalue

Category Examples
Financial asset at fair value Whole fair value movement to profit or loss
through profit or loss
Financial asset at fair value Whole fair value movement to OCI
through OCI
Subsequent sale of the asset
Gain or loss on disposal calculated based on
the carrying amount of the asset at the date of
disposal.
Reclassification of the amounts previously
recognised in OCI is required on sale of a debt
investment classified as FVOCI.
(An entity might make an irrevocable decision
to measure an investment in equity at FVOCI.
Reclassification of the amounts previously
recognised in OCI is not allowed on the sale of
such an asset. However, an amount might be
transferred from an equity reserve to
accumulated profits in this case).
Financial liability at fair value Change in fair value attributed to change in
through profit or loss credit risk to OCI.
Remaining change in fair value to profit or loss

Financial reporting
5 IMPAIRMENT OF FINANCIAL ASSETS
Section overview
„ Introduction
„ Definitions
„ General approach
„ Accounting for the loss allowance: financial assets at amortised cost
„ Simplified approach
5.1 Introduction
Impairment of most non-current assets is covered by IAS 36. IAS 36 operates an
incurred loss model. This means that impairment is recognised only when an
event has occurred which has caused a fall in the recoverable amount of an asset.
Impairment of financial instruments is dealt with by IFRS 9. IFRS 9 contains an
expected loss model. The expected loss model applies to all debt instruments
(loans, receivables etc.) recorded at amortised cost or at fair value through OCI.
It also applies to contract assets (IFRS 15).
The aim of the expected loss model is that financial statements should reflect the
deterioration or improvement in the credit quality of financial instruments held by
an entity. This is achieved by recognising amounts for the expected credit loss
associated with financial assets.
The rules look complex because they have been drafted to provide guidance to
banks and similar financial institutions on the recognition of credit losses on loans
made. However, there is a simplified regime that applies to other financial assets
as specified in the standard (such as trade receivables).
5.2 Definitions
Definition: Credit loss

The difference between all contractual cash flows that are due to an entity in
accordance with the contract and all the cash flows that the entity expects to
receive (i.e., all cash shortfalls), discounted at the original effective interest rate.
Definition: Lifetime expected credit losses

The expected credit losses that result from all possible default events over the
expected life of a financial instrument.
Definition: 12-month expected credit losses

The portion of lifetime expected credit losses that represent the expected credit
losses that result from default events on a financial instrument that is possible
within the 12 months after the reporting date.

5.3 General approach

This approach must be applied to financial assets measured at amortised cost
and financial assets measured at fair value through OCI. The approach also
applies to contract assets unless the entity adopts the simplified approach
described later. (Any impairment losses on financial assets measured at fair
value through profit and loss are automatically recognised in profit or loss).
The objective of the requirements is to recognise lifetime expected credit losses
for all financial instruments for which there have been significant increases in
credit risk since initial recognition (whether assessed on an individual or
collective basis) considering all reasonable and supportable information.
Overview
For those financial assets to which the general approach applies, a loss
allowance measured as the 12-month expected credit losses is recognised at
initial recognition.
The expected credit loss associated with the financial asset is then reviewed at
each subsequent reporting date and remeasured as necessary. The amount of
expected credit loss recognised as a loss allowance depends on the extent of
credit deterioration since initial recognition.
‰ If there is no significant increase in credit risk the loss allowance for that
asset is remeasured to the 12-month expected credit loss as at thatdate.
‰ If there is a significant increase in credit risk the loss allowance for that asset
is remeasured to the lifetime expected credit losses as at that date. This
does not mean that the financial asset is impaired. The entity still hopes to
collect amounts due but the possibility of a loss event has increased.
The two bullets simply differ in terms of how the expected loss is measured.
There is no difference between the necessary double entry in each case.
5.4 Accounting for the loss allowance: financial assets at amortised cost
The movement on the loss allowance is recognised in profit or loss.
The loss allowance balance is netted against the financial asset to which it relates
on the face of the statement of financial position. NB: this is just for presentation
only; the loss allowance does not reduce the carrying amount of the financial asset
in the double entry system.
The loss allowance does not affect the recognition of interest revenue. Interest
revenue is calculated on the gross carrying amount (i.e., without adjustment for
credit losses).

Example: Financial asset at amortised cost
X purchased a loan on 1 January 20X5 and classified as measure data
mortised cost.
Terms:
Nominal value N50million
Coup on rate 10%
Purchase price N48million
Loss allowances (estimated in accordance with IFRS 9):

1January 20X5 N1million
31 December 20X5 N1.5million
31 December 20X6 N1.2million
31 December 20X7 (principal repaid) nil
Required
Show the double entry for each year to maturity of the bond.
The amortisation table and the double entry for the financial asset are not
affected by the existence of the loss allowance.
Accounting for the loss allowances its alongside the accounting treatment for
the financial asset.
The amortisation table is prepared as follows (in the same way as before):
Amortised Interest at Cash Amortised
cost b/f 11.67% receipts costc/f
Year Nm Nm Nm Nm
20X5 48.00 5.60 (5) 48.60
20X6 48.60 5.65 (5) 49.25
20X7 49.25 5.75 (55) nil
(The amortised cost at each date would be more correctly described as

“gross carrying amount of the financial asset”).

Example (continued): Financial asset at amortised cost
The loss allowance is established as a credit balance in the statement of

financial position and is remeasure date ach reporting date.
The redemption of the loan brings certainty that no loss is incurred so the loss
allowance is released to PorL when this happens.
The following table summarises the above double
entries. Credit entries are shown as figures in brackets.
Financial Loss
Cash asset allowance P or L
Nm Nm Nm Nm
20X5
Initial recognition of:
Financial asset (48.00) 48.00
loss allowance (1.00) 1.00
Remeasurement of
loss allowance (0.50) 0.50
Amortised cost 48.60 (1.50)
20X6
Remeasurement of
loss allowance 0.30 (0.30)
49.25 (1.20)
20X7
Remeasurement of
loss allowance 1.20 (1.20)
nil nil
The amortised cost of the financial asset at each year-end is as follows:

20X5 20X6 20X7
Gross carrying amount 48.60 49.25 nil
Loss allowance (1.50) (1.20) nil
47.10 48.05 nil

Financial reporting
5.5 Simplified approach

This applies to trade receivables and contract assets. The approach involves the
recognition of lifetime expected losses for the relevant assets.
The following table summarises when the approach must or may be used.
Financial asset Simplified approach

Trade receivables or contract Must be used.
assets (IFRS 15) that do not
contain a significant financing
component.
Trade receivables or contract May be used if chosen as an accounting
assets that contain a significant policy to be applied consistently to all
financing component. trade receivables or contract assets.
It may be applied separately to trade
receivables and contract receivables.
Example: Simplified approach

N
The trade receivables do not have a significant financing component.
N
Based on historical experience of managing A Ltd’s receivables the directors
identify life time expected losses as 2% of the balance on receivables at anyone
time..
The following double entries are necessary:
1 April 20X6: Initial recognition Dr(N) Cr(N)
Loss allowance (2% of 500,0000) -N8,000) 2,000
A company might use a provision matrix to measure expected lifetime credit

losses. This is a system based on its experience of historical default rates as
updated for forward looking estimates.

Example: Simplified approach

N
The trade receivables do not have a significant financing component.
N
X Plc has constructed the following provision matrix to calculate expected lifetime
losses of trade receivables.
Number of days past due (overdue)
than
Defaultrate 0.3% 1.6% 3.6% 6.6% 10.6%
The expected life time credit loss is measured as follows:
Gross carrying
amount of Lifetime
trade expected credit
receivables Default rate loss
N % N
Current 15,000,000 0.3 45,000
1 to 30 days 7,500,000 1.6 120,000
31 to 60 days 4,000,000 3.6 144,000
61 to 90 days 2,500,000 6.6 165,000
More than 90 1,000,000 10.6 106,000
30,000,000 580,000
must N
The following double entry would be necessary to increase the opening

loss provision to this amount:
Debit Credit
Loss allowance 80,000
The trade receivables would be presented at an amount net of this

in statement al N
N =N 000).

Financial reporting
6 CHAPTER REVIEW
Define financial asset and financial liability
Explain fair value and amortised cost
Apply the correct accounting treatment for the different categories of financial
asset identified by IFRS 9
Account for financial liabilities in accordance with IFRS 9
Account for simple impairment under IFRS 9

Solution
N ×
=
N N N
Year 1 10,000,000 700,000 (600,000) 10,100,000
N
Year 2 10,100,000 707,000 (600,000) 10,207,000
Year 3 10,207,000 714,490 (600,000) 10,321,490
Year 4 10,321,490 722,510 (600,000) 10,444,000
2,844,000 2,400,000
N N
Note that the difference between the interest charged and the interest paid is because
the final payment of the redemption proceeds has not been shown. This contains a
premium N
by the year end.

Skills level
R
E
T
P
A
H
C
IAS 32: Presentation

Accounting for share issues
IFRS 7: Disclosure
Chapter review

Financial reporting
INTRODUCTION
Aim
principles.
Detailed syllabus
statements
provisions of relevant accounting standards (IAS 32, IFRS 7 and IFRS 9 and
IFRS 13) with respect to measurement, recognition, de-recognition and
IAS 32 and IFRS 7 are examinable documents.
Exam context
This chapter explains the basic rules on the presentation and disclosure of financial
instruments.

„ Distinguish between debt andequity
„ Apply split accounting in the books of the issue on the initial recognition of a convertible
bond
„ Explain the IFRS 7 disclosures in respect of financial instruments in overview

Chapter 17: IAS 32 and IFRS 7: Financial instruments: Presentation and disclosure
1 IAS 32: PRESENTATION
Section overview
„ Liability or equity?
„ Compound instruments
„ Transactions in own equity
„ Offsetting
1.1 Liability or equity?

Financial instruments issued by a company must be classified as either liabilities
or equity. This classification should be based on the substance of the contract,
rather than the legal form.
A financial liability is any liability where the issuer has a contractual obligation:
‰ to deliver cash or another financial asset to another entity, or
‰ to exchange financial instruments with another entity on potentially
unfavourable terms.
The owner of an equity instrument is entitled to receive a dividend, but the
company does not have a contractual obligation to make the payment. So equity
does not meet the above definition of a financial liability.
An equity instrument is defined as any contract that offers the residual interest
in the assets of the company after deducting all of the liabilities.
Returns on financial instruments

Returns on financial instruments are reported differently, depending on whether
the instrument is a liability or equity. The classification of the financial instrument
determines the treatment of the interest, dividends, gains and losses.
‰ Interest expense, dividend payments, gains and losses relating toa
financial liability are recognised in the statement of profit or loss.
‰ Distributions to equity holders are debited to equity and shown in the
statement of changes inequity.
Illustration: Classification
Preference shares must be classified as either equity or debt, according totheir
substance. Most preference shares are closer in substance to debt as they have
the following characteristics:
„ a fixed dividend
„ no rights to participate in any surplus on winding up the entity.
The return on a preference share must be classified as dividends or interest in
accordance with the classification of the instrument. Hence the dividend
payments on most preference shares will be disclosed as interest expense in
profit and loss.

Financial reporting
1.2 Compound instruments

A compound instrument is a financial instrument issued that cannot be classified
as simply a liability or as equity by the issuing company because it contains
elements of both debt and equity. An example of a compound instrument is a
convertible bond. The company issues a bond that can be converted into equity
in the future or redeemed for cash. Initially, it is a liability, but it has a call option
on the company’s equity embedded within it.
Typically, a convertible bond pays a rate of interest that is lower than the market
rate for a non-convertible bond (a ‘straight bond’) with the same risk profile. This
is because the terms of the conversion normally allow the bondholder to convert
the bond into shares at a rate that is lower than the market price.
Split accounting for compound instruments

On initial recognition of compound instrument, the credit entry for the financial
instrument must be split into the two component parts, equity and liability.
To do this, the following steps are necessary:
Step 1: Derive the fair value of the liability
Step 2: Calculate the equity component as the difference between the total
amount for the instrument and the fair value of the liability.
Any transaction costs incurred by issuing the instrument should be allocated to
each component, the liability and equity, according to the split in value above.
Comment on the measurement of the debt element

The process starts by deriving a fair value for the liability, on the assumption that
the bond has no conversion rights, and is a ‘straight’ fixed rate bond that will be
redeemed at par at maturity.
If the company had sold a bond with identical features but with no conversion
rights, how much could it have been sold for? To answer this question, it is
necessary to recognise that the fair value of a bond is simply the present value of
the future cash flows that the bond will generate, discounted at the market rate of
interest, which in the following example is 9%.

Example: Convertible bond

A company issues a convertible bond. The details are as follows:
Number of bonds issued 2,000

N Annual
interest rate 5% Market rate at
date of issue 9%
Issue date 1st January 20X5
Redemption dates 31st December 20X7
N N
N N million.)
The bonds should be recorded in the statement of financial position at the date of issue
as follows:
Step 1: Measure the liability component first by discounting the interest payments and
the amount that would be paid on redemption (if not converted) at the prevailing market
interest rate of9%.
31 December Cash flow DF (9%) N
20X5 - interest 100,000 0.9174 91,743
20X6 - interest 100,000 0.8417 84,168
20X7 - interest 100,000 0.7722 77,218
20X7 - principal 2,000,000 0.7722 1,544,367
Value of debt element 1,797,496
Step2: Compare the value of the debtelement to the

cash raised. Thed ifference is the equity element.
Total proceeds 2,000,000

Value of equity element (residual) 202,504
The initial double entry to recognise the bond is as

follows:
Dr Cr
Cash 2,000,000
Liability 1,797,496
Equity 202,504
The financial liability is measured at amortised cost in the accounts of the issuing
company (the borrower).

Financial reporting
The liability component is measured at amortised cost in the usual way at each
subsequent reporting date.
Example(continued): Subsequent measurement of the debt element of

the convertible bond
Brought 9%effective Interest: cash Carried
forward interest payment forward
N N N N
20X5 1,797,496 161,775 (100,000) 1,859,271
20X6 1,859,271 167,334 (100,000) 1,926,605
20X7 1,926,605 173,395 (100,000) 2,000,000
There is no guidance on the subsequent accounting treatment of the equity

element. One approach would be to retain it as a separate component of equity
and then release it to retained earnings when the bond is paid or converted.
At 31 December 20X7 the bond will either be paid or converted. Possible double
entries in each case are asfollows:
If the bond is repaid
Dr Cr
Liability 2,000,000
Cash 2,000,000
and:
Equity component 202,504
Retained earnings 202,504
N
nominal × N
Dr Cr
Liability 2,000,000
Share capital 1,200,000
Share premium 800,000
and:
Equity component 202,504

Practice question
for N
The bond is to be redeemed on 31 December 20X7 (3 years after issue).
The bond holders can take cash or shares with a nominal value of
N this
The bond pays interest at 5% but the market rate of interest for similar
risk bonds without the conversion feature was 9% at the date of issue.
Calculate the liability and equity components of the bond on

initial recognition.
Construct the necessary journal on initial recognition.
Construct an amortisation table to show how the liability
component would be measured over the life of the bond.
Construct the journal to reflect the possible conversion of the
bonds to shares on 31 December 20X7.
1.3 Transactions in own equity

When a company whose shares are traded on the stock market buys back some
of its shares, they are called ‘treasury shares’. The company might then hold on
to the shares until it uses them for a particular purpose, such as awarding shares
to employees in a share grant scheme. The accounting treatment of treasury
shares is that they should be deducted from equity. Any gain or loss on such
transactions are other comprehensive income and should be taken directly to
equity,and should not be reported in profit and loss.
IAS 32 requires that the amount of treasury shares held should be disclosed
separately, either:
‰ on the face of the statement of financial position as a deduction from share
capital, or
‰ offset against share capital and disclosed in the notes to the accounts.
1.4 Offsetting
Offsetting an asset and a liability and presenting a net amount on the face of the
statement of financial position can result in a loss of information to the users. IAS
1 prohibits offset unless required or permitted by an IFRS.
The idea is that offset should only be allowed if it reflects the substance of the
transactions or balances.
IAS 32 adds more detail to this guidance in respect of offsetting financial assets
and liabilities.
IAS 32 requires the presentation of financial assets and financial liabilities in a way
that reflects the company’s future cash flows from collecting the cash from the
asset and paying the cash on the liability. It limits a company’s ability to offset a
financial asset and a financial liability to those instances when the cash flows will
occur at the same time.
The IAS 32 rule is that a financial asset and a financial liability must be offset and
shown net in the statement of financial position when and only when anentity:
‰ currently has a legal right to set off the amounts; and

Financial reporting
‰ intends either to settle the amounts net, or to realise (sell) the asset and
settle the liability simultaneously.
In order for a legal right of set off to be current it: must not be contingent on a
future event and must be. Furthermore, it must be legally enforceable in all of
the following circumstances:
‰ the normal course of business;
‰ the event of default;
‰ the event of insolvency or bankruptcy of the entity and all of the
counterparties
Note: The existence of a legal right to set off a cash balance in one account with
an overdraft in another is insufficient for offsetting to be allowed. The company
must additionally show intent to settle the balances net, and this is likely to be rare
in practice. Consequently, cash balances in the bank and bank overdrafts are
usually reported separately in the statement of financial position, and not ‘netted
off’ against each other.

2 ACCOUNTING FOR SHARE ISSUES
Issue of equity shares

Bonus issues
2.1 Issue of equity shares

This topic is not covered by the rules on financial instruments but is dealt with by
company law. It is included in this chapter for convenience.
When an entity issues new ordinary shares:
‰ The issued shares become a part of equity,and
‰ The entity receives cash from the issue, or possibly assets other than cash
(for which a carrying value isdetermined).
The issue price of new equity shares is usually higher than their face value or
nominal value. The difference between the nominal value of the shares and their
issue price is accounted for as share premium and credited to a share premium
reserve. (This reserve is a part of equity).
Credit
Bank (cash received)
Share capital (nominal value of shares issued)
Share premium (with the excess of the issue
price of the shares over the nominal value)
Transaction costs of issuing new equity shares for cash should be debited
directly to equity.
The costs of the issue, net of related tax benefit, are set against the share
premium account. (If there is no share premium on the issue of the new shares,
issue costs should be deducted from retained earnings).
Example: Share issue

N N
N
The share issue would be accounted for as follows:
Dr (N 000) Cr (N 000)
Cash (200,000 × 250) 50,000
Share capital (200,000 × 25) 5,000
Share premium (200,000 × 250 – 25) 45,000
Share premium 3,000

Cash 3,000

Financial reporting
2.2 Bonus issues

When an entity issues new ordinary shares:
A bonus issue of shares (also called a scrip issue or a capitalisation issue) is an
issue of new shares to existing shareholders, in proportion to their existing
shareholding, for no consideration. In other words, the new shares are issued
‘free of charge’ to existing shareholders.
The new shares are created by converting an equity balance from the statement
of financial position into ordinary share capital.
Illustration: Share issue double entry

Debit Credit
Equity reserve X
Share capital (nominal value of shares issued) X

3 IFRS 7: DISCLOSURE
Objectives of IFRS 7
Significance of financial instruments for financial position and performance
Nature and extent of risks arising from financial instruments
3.1 Objectives of IFRS 7

All companies are exposed to various types of financial risk. Some risks are
obvious from looking at the statement of financial position. For example, a loan
requiring repayment in the next year is reported as a current liability, and users of
the financial statements can assess the risk that the company will be unable to
repay the loan.
However, there are often many other risks that a company faces that are not
apparent from the financial statements. For example, if a significant volume of a
company’s sales are made overseas, there is exposure to the risk of exchange
rate movements.
Example: Financial risks

A UK company has an investment of units purchased in a German company’s
floating rate silver-linked bond. The bond pays interest on the capital, and part
of the interest payment represents bonus interest linked to movements in the
price of silver.
There are several financial risks that this company faces with respect to this
investment.
‰ It is a floating rate bond. So, if market interest rates for bonds decrease, the
interest income from the bonds will fall.
‰ Interest is paid in euros. For a UK company there is a foreign exchange risk
associated with changes in the value of the euro. If the euro falls in value
against the British pound, the value of the income to a UK investor will fall.
‰ A bonus is linked to movements in the price of silver. So, there is exposure
to changes in the price of silver.
‰ There is default risk. The German company may default on payments of
interest or on repayment of the principal when the bond reaches its
redemption date.
IFRS 7 requires that an entity should disclose information that enables users of
the financial statements to ‘evaluate the significance of financial instruments’ for
the entity’s financial position and financial performance.
There are two main parts to IFRS 7:
‰ A section on the disclosure of ‘the significance of financial instruments’ for
the entity’s financial position and financial performance
‰ A section on disclosures of the nature and extent of risks arising from
financial instruments.

Financial reporting
3.2 Significance of financial instruments for financial position and performance
Statement of financial position disclosures

The carrying amounts of financial instruments must be shown, either in the
statement of financial position or in a note to the financial statements, for each
class of financial instrument:
‰ financial assets at fair value through profit or loss;
‰ financial assets at amortised cost;
‰ financial assets at fair value through other comprehensive income;
‰ financial liabilities at fair value through profit or loss; and
‰ financial liabilities measured at amortised cost.
Other disclosures relating to the statement of financial position are also required.
These include the following:
‰ Collateral. A note should disclose the amount of financial assets that the
entity has pledged as collateral for liabilities or contingent liabilities.
‰ Allowance account for credit losses. When financial assets (such as trade
receivables) are impaired by credit losses and the impairment is recorded in
a separate account (such as an allowance account for irrecoverable trade
receivables), the entity should provide a reconciliation of changes in the
account during the period, for each class of financial assets.
‰ Defaults and breaches. For loans payable, the entity should disclose
details of any defaults during the period in the loan payments, or any other
breaches in the loan conditions.
Statement of profit or loss disclosures

An entity must disclose the following items either in the statement of profit or loss
or in notes to the financial statements:
‰ Net gains or losses on financial assets or financial liabilities at fair value
through profit or loss.
‰ Net gains or losses on financial liabilities measured at amortised cost.
‰ Net gains or losses on financial assets at fair value through other
comprehensive income.
‰ Net gains or losses on investments in equity instruments designated at fair value
through other comprehensive income.
‰ Total interest income and total interest expense, calculated using the effective
interest method, for financial assets or liabilities that are not at fair value through
profit or loss.
‰ Fee income and expenses arising from financial assets or liabilities that are not at
fair value through profit or loss.
‰ The amount of any impairment loss for each class of financial asset.

Other disclosures
IFRS 7 also requires other disclosures. These include the following:
‰ Information relating to hedge accounting, for cash flow hedges, fair value
hedges and hedges of net investments in foreign operations. The disclosures
should include a description of each type of hedge, a description of the financial
instruments designated as hedging instruments and their fair values at the
reporting date, and the nature of the risks being hedged.
‰ With some exceptions, for each class of financial asset and financial liability, an
entity must disclose the fair value of the assets or liabilities in a way that permits
the fair value to be compared with the carrying amount for that class. (An important
exception is where the carrying amount is a reasonable approximation of fair
value, which should normally be the case for short-term receivables and
payables.)
3.3 Nature and extent of risks arising from financial instruments

IFRS 7 also requires that an entity should disclose information that enables users
of its financial statements to evaluate the nature and extent of the risks arising
from its financial instruments.
These risks typically include, but are not restricted to:
‰ Credit risk
‰ liquidity risk, and
‰ market risk.
For each category of risk, the entity should provide both quantitative and
qualitative information about the risks.
‰ Qualitative disclosures. For each type of risk, there should be disclosures of the
exposures to risk and how they arise; and the objectives policies and processes
for managing the risk and the methods used to measure therisk.
‰ Quantitative disclosures. For each type of risk, the entity should also disclose
summary quantitative data about its exposures at the end of the reporting period.
This disclosure should be based on information presented to the entity’s senior
management, such as the board of directors or chief executive officer.
Credit risk
Credit risk is the risk that someone who owes money (a trade receivable, a
borrower, a bond issuer, and so on) will not pay. An entity is required to disclose
the following information about credit risk exposures:
‰ A best estimate of the entity’s maximum exposure to credit risk at the end of the
reporting period and a description of any collateral held.
‰ For each class of financial assets, a disclosure of assets where payment is ‘past
due’ or the asset has been impaired.

Financial reporting
Liquidity risk
Liquidity risk is the risk that the entity will not have access to sufficient cash to
meet its payment obligations when these are due. IFRS 7 requires disclosure of:
▪ A maturity analysis for financial liabilities, showing when the contractual
liabilities fall due for payment
▪ A description of how the entity manages the liquidity risk that arises from
this maturity profile of payments.
Market risk
Market risk is the risk of losses that might occur from changes in the value of
financial instruments due to changes in:
▪ Exchange rates,
▪ interest rates, or
▪ market prices.
An entity should provide a sensitivity analysis for each type of market risk to
which it is exposed at the end of the reporting period. The sensitivity analysis
should show how profit or loss would have been affected by a change in the
market risk variable (interest rate, exchange rate, market price of an item) that
might have been reasonably possible at that date.
Alternatively, an entity can provide sensitivity analysis in a different form, where it
uses a different model for analysis of sensitivity, such as a value at risk (VaR)
model. These models are commonly used by banks.
4 CHAPTER REVIEW
Distinguish between debt and equity
Apply split accounting in the books of the issue on the initial recognition of
a convertible bond
Explain the IFRS 7 disclosures in respect of financial instruments in overview

Financial reporting
a)
31st December Cash(N) factor 9% value(N)

20X5 - interest 100,000 0.9174 91,743
20X6 - interest 100,000 0.8417 84,168
20X7 - interest 100,000 0.7722 77,218
20X7 - principal 2,000,000 0.7722 1,544,367
Fair value of bond 1,797,496
Value of equity (balance) 202,504
Proceeds from issue of bond 2,000,000
b) Journal on initial recognition Dr(N) Cr(N)

Cash 2,000,000
Liability 1,797,496
Equity 202,504
c) Amortisationtable
Liability at Finance charge Interest Liability at
start of year at9% paid end of year
N N N N
20X5 1,797,496 161,775 (100,000) 1,859,271
20X6 1,859,271 167,334 (100,000) 1,926,605
20X7 1,926,605 173,395 (100,000) 2,000,000
d) Journal on conversion to shares N N

Bond 2,000,000
Equity - option proceeds 202,504
Share capital 1,200,000
Share premium 1,002,504

Contents
The nature of a group and consolidated accounts
Consolidated statement of financial position
IFRS 3: Business combinations
Consolidation double entry
Chapter review

Financial reporting
INTRODUCTION
Aim
principles.
Detailed syllabus
D Preparing and presenting financial statements of simple group (parent, one
subsidiary and an associate)
a Explain the concept of group especially a simple group and the objectives of
preparing group financial statements.
b Discuss the provisions of the relevant accounting standards for the
preparation and presentation of financial statements of simple group – (IAS
27, IAS 28, IFRS 3 and IFRS 10), including the use of fair value for non-
controlling interest.
c Calculate non-controlling interest using alternative methods andeffect
necessary adjustments required to prepare the financial statements of
simple group.
a Prepare and present statement of financial position of a simple group (one
subsidiary and an associate) in accordance with the provisions of relevant
standards (IAS 1, IAS 27, IAS 28, IFRS 3 and IFRS 10).
Exam context
This chapter explains the issue underlying the need for group accounts and the process of
consolidation.

„ Describe the concept of a group as a single economic unit
„ Define using simple examples subsidiary, parent and control
„ Describe situations when control is presumed to exist
„ Identify and describe the circumstances in which an entity is required to prepare and
present consolidated financial statements
„ Prepare basic a consolidated statement of financial position including the calculation of
goodwill, non-controlling interest and consolidated post acquisition reserves

Chapter 18: Consolidated accounts: Statements of financial position - Basic approach
1 THE NATURE OF A GROUP AND CONSOLIDATED ACCOUNTS
Group as a single economic entity

A group of companies: parent and subsidiaries
Situations where control exists
Purpose and nature of consolidated financial statements
The requirement to prepare consolidated accounts
Sundry accounting issues
1.1 Group as a single economic entity
Illustration: Single economic entity

A Limited (a car manufacturer) buys 100% of B Limited (an automotive parts
manufacturer).
The 100% ownership gives A Limited complete control over B Limited.
A Limited’s Businesss has changed as a result of buying B Limited.
It was a car manufacturer. Now it is a car manufacturer and a manufacturer of
automotive parts.
The two parts of the business are operated by two separate legal entities (A Limited
and B Limited). However, the two parts of the business are controlled by the
management of A Limited.
In substance, the two separate legal entities are a single economic entity.
IFRS contains rules that require the preparation of a special form of financial
statements (consolidated financial statements also known as group accounts) in
circumstances like the one described above.
This chapter explains some of the rules contained in the following standards:
‰ IFRS 10: Consolidated financial statements
‰ IFRS 3: Business combinations.

Financial reporting
1.2 A group of companies: parent and subsidiaries
Definitions: Group, parent and subsidiary

Group: A parent and its subsidiaries
Parent: An entity that controls one or more entities.
Subsidiary: An entity that is controlled by another entity.
A group consists of a parent entity and one or more entities that it has control
over. These are called subsidiaries.
The entity that ultimately controls all the entities in the group is called the parent.
Some parent companies have no assets at all except shares in the subsidiaries
of the group. A parent whose main assets (or only assets) are shares in
subsidiaries is sometimes called a holding company.
Control
An entity is a subsidiary of another entity if it is controlled by that other entity.
Definition: Control
An investor controls an investee when:
a. it is exposed, or has rights, to variable returns from its involvement with the
investee; and
b. it has the ability to affect those returns through its power over the investee.
In other words, an investor controls an investee, if and only if, it has all the
following:
‰ power over the investee;
‰ exposure, or rights, to variable returns from its involvement with the
investee; and
‰ ability to use its power over the investee to affect the amount of its returns
1.3 Situations where control exists

The above definition of control is quite complicated.
In practice, the vast majority of cases involve a company achieving control of
another through buying a controlling interest in its shares.
Furthermore, in the vast majority of cases obtaining a controlling interest means
buying shares which give the holder more than 50% of the voting rights in the
other company.

Illustration: Wholly owned subsidiary

A owns 100% of B’s voting share capital.
A This 100% holding is described as a controlling

interest and gives A complete control of B.
100%
B would be described as a wholly owned
subsidiary.
B
A company does not have to own all of the shares in another company in order to
controlit.
Illustration: Partly owned subsidiary

A This 80% holding is described as a controlling

interest and gives A complete control of B.
80% B would be described as a partly owned
subsidiary.
B Other parties own the remaining 20% of the shares.
They have an ownership interest in B but do not
have control.
This is described as a non-controlling interest.
Non-controllingi nterest (NCI) is defined by IFRS
10 as: “the equity in a subsidiary not attributable
,directly or indirectly,to a parent.”
Control is assumed to exist when the parent owns directly, or indirectly through
other subsidiaries, more than half of the voting power of the entity, unless in
exceptional circumstances it can be clearly demonstrated that such control does
notexist.
A A owns a controlling interest in B . B owns a

60% controlling interest in C.
Therefore, A controls C indirectly through its
B ownership of B.
C is described as being a sub-subsidiary of A.
70%
Consolidation of sub-subsidiaries is not in this syllabus
C

Financial reporting
In certain circumstances, a company might control another company even if it owns

shares which give it less than half of the voting rights. Such a company is said to
have de facto control over the other company. (De facto is a Latin phrase which
translates as of fact. It is used to mean in reality or to refer to a position held in
fact if not by legal right).

The other shares are held by a large number of unrelated investors none of whom
individually own more than 1% ofB.
A This 45% holding probably gives A complete

control of B.
45% It would be unlikely that a sufficient number of
the other shareholders would vote together to
B stop A directing the company as it wishes.
A company might control another company even if it owns shares which give it
less than half of the voting rights because it has an agreement with other
shareholders which allow it to exercise control.

A further10% is held by A’s bank who have agreed to use their vote as directed
by A.
A
This 45% holding together with its power to use the
45% votes attached to the banks shares gives A complete
control of B.
B
It was stated above but is worth emphasising that in the vast majority of cases
control is achieved through the purchase of shares that give the holder more than
50% of the voting rights in a company.

1.4 Purpose and nature of consolidated financial statements

An investment in a company is usually included in the statement of financial
position of the parent at cost. This does not reflect the substance of the situation.
The directors have control of the net assets of the subsidiary and use these to
generate profit.
To solve this problem IFRS requires that where a company holds a subsidiary it
must prepare group accounts in addition to its own accounts.
The type of group accounts specified by IFRS are called consolidations.
The purpose of consolidated financial statements is to provide financial statements
that have meaning and relevance to users. When a parent acquires a subsidiary,
both the parent and the subsidiary remain legally separate entities.
However, in practice they operate as if they were one organisation. Consolidated
financial statements reflect the reality (or substance) of the situation: the group is
a single economic unit.
In preparing consolidated financial statements:
‰ the assets and liabilities of the parent and its subsidiaries are combined in a
single consolidated statement of financial position.
‰ the profits of the parent and its subsidiaries, and their other comprehensive
income, are combined into a single in a consolidated statement of
In other words, a lot of the numbers in the consolidated financial statements are
constructed as a simple cross cast of the balance in the financial statements of
the parent and its subsidiary (or subsidiaries).
Example: Consolidated
figures
Parent Subsidiary Consolidated
Property, plant and

equipment 1,000 + 500 = 1,500
Inventory 500 + 800 = 1,300
Sales 2,000 + 1,000 = 3,000

It is not always as straightforward as this. Sometimes there is a need for
adjustments in the cross cast. This will be explained later.
Note that the share capital and reserves for the consolidated balance sheet are
not calculated simply by adding the capital and reserves of all the companies in
the group!). This is explained later.

Financial reporting
1.5 The requirement to prepare consolidated accounts

IFRS 10 states that, with certain exceptions, a parent must present consolidated
financial statements in which it consolidates its investments in subsidiaries. In
other words, a parent must prepare consolidated financial statements for the
group as a whole.
Exception to this rule

There is an exception to this rule. This allows a parent that is itself a subsidiary
not to prepare consolidated financial statements.
A parent need not present consolidated financial statements if (and only if) all the
following conditions apply:
‰ The parent itself (X) is a wholly-owned subsidiary, with its own parent(Y).
Alternatively, the parent (X) is a partially-owned subsidiary, with its own
parent (Y), and the other owners of X are prepared to allow it to avoid
preparing consolidated financial statements.
‰ The parent’s debt or equity instruments are not traded in a publicmarket.
‰ The parent does not file its financial statements with a securities
commission for the purpose of issuing financial instruments in a public
market.
‰ The parent’s own parent, or the ultimate parent company (for example, the
parent of the parent’s parent), does produce consolidated financial
statements for public use that comply with IFRS.
All subsidiaries
Consolidated financial statements must include all the subsidiaries of the parent
(IFRS 10). There are no grounds for excluding a subsidiary from consolidation.
1.6 Sundry accounting issues
Common reporting date

IFRS 10 requires that the financial statements of the parent and its subsidiaries
that are used to prepare the consolidated financial statements should all be
prepared with the same reporting date (the same financial year-end date), unless
it is impracticable to do so.
If it is impracticable for a subsidiary to prepare its financial statements with the
same reporting date as its parent, adjustments must be made for the effects of
significant transactions or events that occur between the dates of the subsidiary's
and the parent's financial statements. In addition, the reporting date of the parent
and the subsidiary must not differ by more than three months.
Uniform accounting policies

Since the consolidated accounts combine the assets, liabilities, income and
expenses of all the entities in the group, it is important that the methods used for
recognition and measurement of all these items should be the same for all the
entities in the group.
IFRS 10 therefore states that consolidated financial statements must be prepared
using uniform accounting policies. The policies used to prepare the financial
statements in all the entities in the group must be the same.

2 CONSOLIDATED STATEMENT OF FINANCIAL POSITION
The basicapproach
Example 1: To illustrate the basics
Pre- acquisition and post-acquisition profits
Goodwill
Non-controlling interest
Suggested step by step approach
2.1 The basic approach
Definition
Consolidated financial statements: The financial statements of a group presented
as those of a single economic entity.
The technique of consolidation involves combining the financial statements of the

parent and its subsidiaries. We will first explain how to consolidate the statement
of financial position. Consolidation of the statement of comprehensive income will
be covered in chapter 19.
Question structure
There are often two major stages in answering consolidation questions:
‰ Stage 1 involves making adjustments to the financial statements of the
parent and subsidiary to take account of information provided. This might
involve correcting an accounting treatment that has been used in preparing
the individual company accounts.
‰ Stage 2 involves consolidating the correct figures that you have produced.
The early examples used to demonstrate the consolidation technique look only at
step 2. It is assumed that the financial statements provided for the parent and its
subsidiary are correct.
Approach in this section

This section will demonstrate the techniques used to consolidate the statements of
financial position using a series of examples introducing complications one at a
time.
The examples will be solved using an approach that you might safely use to
answer exam questions. This approach is quick but it does not show how the
double entry works. The double entry will be covered in section 3 of this chapter
so that you are able to understand the flow of numbers in the consolidation and
able to prepare journal entries if asked to do so.

Financial reporting
Note the following features in following examples:

‰ The asset in the parent’s statement of financial position representing the
cost of investment in the subsidiary disappears in theconsolidation.
‰ Each consolidated asset and liability is constructed by adding together the
balances from the statements of financial position of the parent and the
subsidiary.
‰ The share capital (and share premium) in the consolidated statement of
financial position is always just the share capital (and share premium) of
the parent. That of the subsidiary disappears in the consolidation process.
Major workings
There are three major calculations to perform in preparing a consolidated
statement of financial position:
‰ Calculation of goodwill
‰ Calculation of consolidated retained earnings
‰ Calculation of non-controlling interest
In order to calculate the above figures (all of which will be explained in the
following pages) information about the net assets of the subsidiary at the date of
acquisition and at the date of consolidation is needed.
This is constructed using facts about the equity balances (as net assets = equity).
At date of At date of
Share capital
Share premium
Retainedearnings*
Net assets
*Retained earnings are also known as unappropriated profits or
You are not yet in a position to full understand this but all will be explained in the
following pages.

2.2 Example1-To illustrate the basics
Example: Very basic example

P acquired 100% of the equity shares of S on incorporation of S (i.e., when S was first
established as a company).
The date of this transaction was 31 December 20X1 (this known as the date of
acquisition).
this me
S had net assets (total assets minus total liabilities) when it was first set up of
The statements of financial position P and S as at 31 December 20X1 (the date of

acquisition) were as follows.
P S
Non-current assets:
Property, plantand equipment 640,000 125,000
Investment in S 120,000 -
Current assets 140,000 20,000
900,000 145,000
Equity
Share capital 200,000 80,000
Share premium 250,000 40,000
Retained earnings 350,000 –
800,000 120,000
Current liabilities 100,000 25,000
900,000 145,000
A consolidated statement of financial position as at 31 December 20X1 can be

prepared as follows:
Non-current assets:
(640,000 + 125,000) 765,000
Property, plant and equipment
Current assets (140,000 + 20,000) 160,000
925,000
Equity
Share capital (parent company only) 200,000
Share premium (parent company only) 250,000
800,000
Current liabilities (100,000 + 25,000) 125,000
925,000
Note: In practice, there is no reason to prepare a consolidated statement of

financial position when a subsidiary is acquired. However, it is used here to
illustrate the basic principles of consolidation, before going on to consider what
happens after the subsidiary has been acquired.

Financial reporting
Observations
The asset in the parent’s statement of financial position representing the cost of
investment in the subsidiary disappears in the consolidation.
Each consolidated asset and liability is constructed by adding together the
subsidiary.
The share capital (and share premium) in the consolidated statement of financial
position is always just the share capital (and share premium) of the parent. That
of the subsidiary disappears in the consolidation process.
Closing comment
The cost of investment was the same as the net assets acquired (N120,000). This
is very rarely the case. Usually there is a difference. This difference is called
goodwill. It will be explained later.
2.3 Pre-acquisition and post-acquisition profits

Subsidiaries are usually acquired after they have been in business for some time
rather than when they were incorporated.
This means that the acquired subsidiary will have retained earnings at the date of
the acquisition. These are called pre-acquisition profits.
Only profits earned by the subsidiary since the date of acquisition are included as
retained earnings in the consolidated financial statements. These are called post-
acquisition retained earnings.
Pre-acquisition profits of a subsidiary are not included as retained earnings in the
consolidated financial statements.
The working for the consolidated retained earnings balance is as follows:
Illustration: Consolidated retained earnings
N
All of P’s retained earnings X
P’s share of the post-acquisition retained earnings of S X
Consolidated retained earnings X
Other reserves
Sometimes a subsidiary has reserves other than retained earnings. The same
basic rules apply.
Only that part of a subsidiary’s reserve that arose after the acquisition date is
included in the group accounts (and then only the parent’s share of it).

Example: Consolidated statement of financial position with share of post-

acquisition profits of subsidiary
P acquired 100% of the share capital of Son1January 20 X 1 for N 200,000.
The balance on the retained earnings account of S was N80,000 at this date.
The statements of financial position P and S as at 31 December 20X1 were as
follows.
P S
N N
Non-current assets:
Property, plant and equipment 680,000 245,000
1,055,000 335,000
Equity
Retained earnings 470,000 140,000
900,000 260,000
1,055,000 335,000
P Group: Consolidated statement of financial position at 31
December 20X1
N
Non-current assets:
Property, plant and equipment (680,000 + 245,000) 925,000
Current assets (175,000 + 90,000) 265,000
1,190,000
Equity
Share capital (parent company only) 150,000
Share premium (parent company only) 280,000
Consolidated retained earnings (see working) 530,000
960,000
Currentliabilities (155,000 + 75,000) 230,000
1,190,000

Financial reporting
Example (continued): Workings

Net assets summary of S:
consolidation acquisition Post acqn
Retained earnings 140,000 80,000 60,000
Net assets 140,000 200,000
Consolidated retained profits: N
All of P’s retained earnings 470,000

P’s share of the post-acquisition retained 60,000
earnings of S (100% of 60,000 (see
above))
530,000
Observations
investment in the subsidiary disappears in the consolidation.
subsidiary.
The consolidated retained profits is made up of the parent’s retained profits plus
the parent’s share of the growth in the subsidiary’s retained profits since the date
of acquisition.
Closing comment
The cost of investment was the same as the net assets acquired (N120,000). This
is very rarely the case. Usually there is a difference. This difference is called
goodwill. It will be explained later.

2.4 Goodwill
In each of the two previous examples the cost of investment was the same as the
net assets of the subsidiary at the date of acquisition.
In effect what has happened in both examples is the cost of investment has been
replaced by the net assets of the subsidiary as at the date of acquisition.
The net assets have grown since acquisition to become the net assets at
consolidation. These have been included as part of the net assets of the group but
remember that the consolidated retained earnings includes the parent’s share of
post-acquisition retained earnings so everything balances.
Do not worry if this is not obvious to you. The double entry is explained in section
3 of this chapter.
In almost all cases the cost of investment will be different to the net assets
purchased. The difference is called goodwill.
Definition: Goodwill
Goodwill: An asset representing the future economic benefits arising from other
assets acquired in a business combination that are not individually identified and
separately recognised.
When a parent buys a subsidiary the price it pays is not just for the assets in the
statement of financial position. It will pay more than the value of the assets
because it is buying the potential of the business to make profit.
The amount it pays in excess of the value of the assets is for the goodwill.
IFRS 3 Business combinations, sets out the calculation of goodwill as foliows:
Illustration: Goodwill
N.B. All balances areas at the date of
acquisition.
Consideration transferred (cost of the business

combination)
The net of the acquisition date amounts of
identifiable assets acquired and liabilities assumed
(measured in Accordance with IFRS3)
Good will recognised
The above calculation compares the total value of the company represented by
what the parent has paid for it and the non-controlling interest to the net assets
acquired at the date of acquisition.
The guidance requires the net of the acquisition date amounts of identifiable
assets acquired and liabilities assumed (measured in accordance with IFRS
3). This will be explained later.
The guidance also refers to non-controlling interest. This will be explained later
but first we will present an example where there is no non-controlling interest.

Financial reporting

acquisition profits and goodwill
for

follows:
P S
N N
Assets:
Investment in S, at cost 230,000 -
Other assets 570,000 240,000
800,000 240,000
Equity
740,000 195,000
800,000 240,000

20 X 1
Goodwill (see working) 60,000

Other assets (570 + 240) 810,000
Equity
Share capital (P only) 200,000
Share premium (P only) 100,000
765,000
Current liabilities (60 + 40) 105,000

Net assets 195,000 170,000*
Goodwill N
Cost of investment 230,000
Non-controllinginterest nil
230,000
Net assets at acquisition 100% of 170,000*
(see above) (170,000)
60,000

P’s share of the post-acquisition retained
earnings of S (100% of 25,000(see 25,000
above))
465,000
Observations
investment in the subsidiary disappears in the consolidation. It is taken into the
goodwill calculation.
subsidiary.
The consolidated retained profits is made up of the parent’s retained profits plus
the parent’s share of the growth in the subsidiary’s retained profits since the date
of acquisition.
Accounting for goodwill

Goodwill is recognised as an asset in the consolidated financial statements.
It is not amortised but is tested for impairment on an annual basis.

Financial reporting
Practice questions 1
Calculate the goodwill arising on acquisition in each of the following cases on the
assumption that it is the parent company’s policy to measure non- controlling
interest at acquisition as aproportionate share of net assets.
a) A Ltd bought 60% of B Limited on 1 January 2005 for N766,000. At this
date B limited had net assets of N800,000.
b) C Ltd bought 55% of D Limited several years ago for
c) 1,000,000.
At this date D limited had share capital of N500,000 and retained earnings of
N 750,000.
d) E Ltd bought 90% of F Limited several years ago for N1,750,000.
At this date F limited had share capital of N100,000, share premium of
N48,000, are valuation reserve of N120,000 and retained earnings of
N250,000.
e) G Ltd bought 40% of H Limited several years ago for N1,000,000.
Circumstances are such that this holding gives G Ltd defacto control of H
Limited.
At this date H limited had share capital of N500,000 and retained earnings of
N750,000.
2.5 Non-controlling interest

When a parent entity acquires less than 100% of the equity shares in a
subsidiary, the remainder of the shares in the subsidiary are held by other
shareholders. These are called the non-controlling interest (NCI) in the
subsidiary. The abbreviation NCI is used for non-controlling interests.
For example, P might acquire 60% of the shares in S.
‰ It has acquired 60% of the ‘equity’ ownership of S.
‰ The remaining 40% of the equity in S is owned by the non-controlling
interest.
Non-controlling interest (NCI) is defined by IFRS 10 as: ‘the equity in a subsidiary
not attributable, directly or indirectly, to a parent.’
All of the assets and liabilities of S are consolidated just as before. However, part
of the net assets that have been consolidated belongs to the NCI. A figure for the
NCI is recognised in equity to show their ownership interest in the net assets.
Measuring the NCI

The NCI at the reporting date made up as follows:
Illustration: Consolidated retained earnings
N
NCI at the date of acquisition X
NCI’s share of the post-acquisition retained earnings of S NCI’s X
share of each other post-acquisition reserves of S (if any) X

There are two ways of measuring the NCI at the date of acquisition.
‰ As a percentage of the net assets of the subsidiary at the date of
acquisition; or
‰ At fair value as at the date ofacquisition.
The first technique is the easier of the two because it allows for the use of a short
cut. Also, it is far the more common in practice.
The different approaches will obviously result in a different figure for NCI but
remember that the NCI at acquisition is also used in the goodwill calculation. This
is affected also.

acquisition profits, goodwill and NCI
for
It is P’s policy to recognize non-controlling interest at the date of acquisition as a

proportionate share of net assets.
follows
P S
N N
Assets:
Other assets 570,000 240,000
800,000 240,000
Equity
740,000 195,000
800,000 240,000
20X1

Other assets (570 + 240) 810,000
Equity
760,000
Non-controlling interest (see working) 39,000
799,000

Net assets 195,000* 170,000
Non-controlling interest N
NCI’s share of net assets at the date of acquisition
(20% u170,000) 34,000
NCI’s share of the post- acquisition retained
earningsof S (20% of 25,000 (see above)) 5,000
NCI’s share of net assets at the date of consolidation 39,000
Goodwill N
Non-controlling interest at acquisition 34,000
264,000
Net assets at acquisition (see above) (170,000)
94,000

P’s share of the post-acquisition retained arnings of
S (80% of 25,000 (see above)) 20,000
460,000

Financial reporting
The NCI at the date of consolidation has been calculated as NCI share of net
assets at acquisition plus the NCI share of profit since the date of acquisition.
NCI share of profit since the date of acquisition is the same as the NCI share of
net assets since the date of acquisition.
Therefore, the NCI at the date of consolidation is simply the NCI share of
net assets at the date of consolidation.
Net assets 195,000* 170,000
NCI’s share of net assets at the date of
consolidation (20% u195,000*)
This short cut is not available if the NCI at acquisition is measured at fair value.

NCI at fair value at the date of acquisition
Example: NCI at date of acquisition measured at fair value

Continuing the earlier example with the extra information that the fair value ofthe
NCI at acquisition was 40,000.
Net assets summary of S
At date of At date of Post acqn
consolidation acquisition
Net assets 195,000 170,000
Figures under both methods are shown so that you can see the
difference between the two.
NCI at fair share of

value net assets
Non-controlling interest N N
NCI at the date of acquisition
at fair value 40,000
share of net assets (20% u170,000) 34,000
NCI’sshareofthepost-acquisition
retained earnings ofS
(20% of 25,000 (see above)) 5,000 5,000
NCI’s share of net assets at the date
of consolidation 45,000 39,000
Goodwill N N
Cost of investment 230,000 230,000
Non-controlling interest at acquisition 40,000 34,000
270,000 264,000
Net assets at acquisition (see above) (170,000) (170,000)
100,000 94,000

Financial reporting
Practice questions
Calculate the goodwill arising on acquisition in each of the following cases
on the assumption that it is the parent company’s policy to measure non-
controlling interest at a cquisition at its fairvalue.
for
this
ntrolling
for
this capital retai
for
this capital premium
2.6 Suggested step by step approach

To prepare a consolidated statement of financial position as at the acquisition
date, the following steps should be taken.
Step 1. Establish the group share (parent company share) in the subsidiary and
the percentage owned by non-controlling interests.
Step 2: Perform double entry to record any individual company adjustments that
might be necessary. Mark these in the face of the question. The information can
be lifted into workings later so that the marker can understand what you have
done.
Step 3: Set out a pro-forma (skeleton) statement of financial position and fill in
the easy numbers (for example those assets and liabilities that are a straight
cross cast and the share capital)
Step 4. Calculate the net assets of the subsidiary S at the acquisition date and at
the end of the reportingperiod
Step 5. Calculate thegoodwill
Step 6. Calculate the non-controlling interest.
Step 7. Calculate consolidated retained earnings.

Practice question
for
It is P’s policy to recognise non-controlling interest at the date of

acquisition as a proportionate share of net assets.
The statements of financial position P and S as at 31 December 20X1
were as follows:
Assets: P(N) S(N)
Other assets 500,000 350,000
950,000 350,000
Equity
750,000 200,000
950,000 350,000
Prepare a consolidated statement of financial position as at

31 December 20X1.

Financial reporting
Practice question
for
It is P’s policy to recognise non-controlling interest at the date of

acquisition at fairvalue.
The fair value of the non-controlling interest at the date of acquisition was
The statements of financial position P and S as at 31 December 20X1

were asfollows:
Assets: P(N) S(N)
Other assets 500,000 350,000
950,000 350,000
Equity
750,000 200,000
950,000 350,000

31 December 20X1.
3 IFRS 3: BUSINESS COMBINATIONS
Acquisition method
Acquisition date amounts of assets acquired and liabilities assumed
3.1 Introduction to IFRS3

Objective of IFRS 3
The objective of IFRS 3 is to improve the relevance, reliability and comparability
of information reported about business combinations and their effects.
It establishes principles and requirements for:
‰ the recognition and measurement of identifiable assets acquired, liabilities
assumed and non-controlling interest in the acquiree;
‰ the recognition and measurement of goodwill (or a gain from a bargain
purchase); and
‰ disclosures that enable users to evaluate the nature and financial effects of
a business combination
‰
3.2 Acquisition method
All business combinations are accounted for by the acquisition method which
involves:
‰ identifying the acquirer;
‰ determining the acquisition date;
‰ recognising and measuring the identifiable assets acquired, the liabilities
assumed and any non-controlling interest in the acquiree; and
‰ recognising and measuring goodwill or a gain from a bargain purchase
Identifying the acquirer

It might be difficult to identify an acquirer:
‰ The acquirer is usually the combining entity whose relative size is
significantly greater than that of theother(s).
‰ In a business combination affected by transferring cash (other assets) or by
incurring liabilities the acquirer is usually the entity that makes the transfer
or incurs the liabilities.
‰ In a business combinations affected by exchange of equity interests the
acquirer is usually the entity that issues equity.
Also note that the acquirer is usually the entity:
‰ whose owners have the largest portion of the voting rights in the combined
entity;
‰ whose owners have the ability determine the composition of the governing
body of the combined entity;
‰ whose (former) management dominates the management of the combined
entity;
‰ that pays a premium over the pre-combination fair value of the equity
interests of the others
Determining the acquisition date
Acquisition date is the date on which the acquirer effectively obtains control of the
acquiree.
This generally the closing date (date of transfer of consideration and when net
assets are acquired) but might be before or after this date depending on
circumstances.
Goodwill
Goodwill was defined in an earlier section which explained that it is measured as
Illustration: Goodwill
N.B. All balances are as at the date of
acquisition.
Consideration transferred (cost of the business

combination)
The net of the acquisition date amounts of
identifiable assets acquired and liabilities assumed
(measured in Accordance with IFRS 3)
Good will recognised
follows:
The section also explained that the non-controlling interest may be stated as
either:
‰ a proportionate share of the identifiable assets acquired and liabilities
assumed; or
‰ at fair value as at the date of acquisition
Issues to address:
IFRS 3 gives guidance on:
‰ cost of a business combination;
‰ recognition and measurement of identifiable assets and liabilities assumed;
and
‰ accounting for goodwill.
Cost (consideration transferred)

Consideration transferred is measured at fair value which is the sum of
acquisition-date fair values of:
‰ assets transferred by the acquirer;
‰ liabilities incurred by the acquirer to former owners of the acquiree; and
‰ equity interests issued by the acquirer (except for share-based payment
awards exchanged for those held by the acquiree’s employees – IFRS 2
applies)
If the consideration includes assets or liabilities of the acquirer carried at amounts
that differ from their fair values at the acquisition date, these are revalued with
gains and losses taken to P&L.
Consideration includes any asset or liability resulting from a contingent
consideration arrangement:
‰ recognised at acquisition-date fair value; and
‰ classified as a liability or equity on the basis of guidance in IAS 32 or other
applicableIFRSs.
A right to the return of previously transferred consideration is classified as an
asset if specified conditions are met.
Acquisition-related costs
Acquisition-related costs (costs the acquirer incurs to effect a business
combination) are recognised as expenses in the periods in which the costs are
incurred and the services are received.
Costs of issuing debt or equity (perhaps to pay for the business combination) are
not acquisition costs. These costs are accounted for in accordance with IAS 39
Financial Instruments: Recognition and Measurement.
3.3 Acquisition date amounts of assets acquired, and liabilities assumed

The way that the following rules impact consolidation is shown in the next
chapter.
Core principle
An acquirer of a business must recognise assets acquired and liabilities assumed
at their acquisition date fair values and disclose information that enables users to
evaluate the nature and financial effects of the acquisition.
To support this IFRS 3R sets out:
▪ a recognition principle;
▪ classification guidance; with
▪ a measurement principle.
There are specified exceptions to each of these.
Any asset acquired or liability assumed is subsequently measured in accordance
with applicable IFRS. There are also exceptions to this rule.
Recognition principle
An acquirer must recognise (separately from goodwill), identifiable assets
acquired, liabilities assumed and any non-controlling interest in the acquiree as of
the acquisition date.
To qualify for recognition identifiable assets acquired and liabilities assumed
must meet the definitions of assets and liabilities set out in The Conceptual
Framework as at the acquisition date.
This might result in recognition of assets and liabilities not previously recognised
by the acquiree.
Classification guidance
Identifiable assets acquired and liabilities assumed must be classified
(designated) as necessary at the acquisition date so as to allow subsequent
application of appropriate IFRS.
The classification is based on relevant circumstances as at the acquisition date
with two exceptions:
‰ classification of a lease contract in accordance with IFRS 16: Leases; and
‰ classification of a contract as an insurance contract in accordance with
IFRS 4: Insurance Contracts.
Classification in these cases is based on circumstances at the inception of the
contract or date of a later modification that would change the classification.
Measurement principle
Identifiable assets acquired and the liabilities assumed are measured at their
acquisition date fair values.
Measurement period
Initial accounting for goodwill may be determined on a provisional basis and must
be finalised by the end of a measurement period.
This ends as soon as the acquirer receives the information it was seeking about
facts and circumstances that existed at the acquisition date but must not exceed
one year from the acquisition date.
During the measurement period new information obtained about facts and
circumstances that existed at the acquisition date might lead to the adjustment of
provisional amounts or recognition of additional assets or liabilities with a
corresponding change to goodwill.
Any adjustment restates the figures as if the accounting for the business
combination had been completed at the acquisition date.

3.4 Accounting for goodwill
Positive goodwill - Excess of cost of combination over share of net assets

After initial recognition goodwill is measured at cost less any accumulated
impairment losses.
‰ Goodwill acquired in a business combination is notamortised.
‰ It is tested for impairment annually, or more frequently if events or changes
in circumstances indicate that it might be impaired, in accordance with IAS
36, Impairment of Assets.
Gain from a bargain purchase (“Negative goodwill”)

A bargain purchase is a business combination in which the calculation of goodwill
leads to a negative figure.
When this happens the acquirer must reassess whether it has correctly identified
all of the assets acquired and all of the liabilities assumed and must recognise any
additional assets or liabilities that are identified in that review.
The acquirer must then review the procedures used to measure the amounts this
IFRS requires to be recognised at the acquisition date for all of the following:
‰ the identifiable assets acquired and liabilities assumed;
‰ the non-controlling interest in the acquiree (if any); and
‰ the consideration transferred.
Any amount remaining after applying the above requirements is recognised as a
gain in profit or loss on the acquisition date.
4 CONSOLIDATION DOUBLE ENTRY
Section overview
„ Introductory comment
„ Calculating goodwill
„ Calculating NCI
„ Calculating consolidated retained earnings
„ Tutorial note
4.1 Introductory comment

This section has been prepared for your wider professional education rather than
for the exam. Treat it as a reference section that shows how the double entry of
consolidation works.
We recommend that you do not answer questions using “T accounts” as
shown in this section but use schedules as shown in the earlier sections
Usually, journals are prepared to process changes in the general ledger. This is
not the case of the journals in this section. There is no general ledger for the
group accounts. Consolidated financial statements are prepared from
independent sets of financial statements which are extracted from separate
general ledgers. Information from these independent financial statements is
transferred to working papers where the consolidation is performed.
The journals described in this refer to adjustments made to numbers in those
working papers.
The example used earlier at paragraph 2.5 of this chapter will be used to
illustrate the double entry.
4.2 Calculating goodwill

The cost of investment account is renamed the cost of control account. This is
the account used to calculate goodwill. P’s share of net assets is compared with
the cost of investment in this account by transferring in P’s share of each of S’s
equity balances at the date of acquisition.
Illustration: Double entry to calculate goodwill

Debit Credit
Share capital of S 40,000
Cost of control (80% of 50,000) 40,000
Share premium of S 16,000

Retained earnings of S 80,000

Being: Transfer of P’s share of S’s share capital, share premium and
retained earnings to cost of control account as at the date of
acquisition.
The balance on the cost of control account is the goodwill figure.
Example (continued): Cost of control account

Cost of control (goodwill)
N N
1) P’sshare of S’s share
Costofinvestment 230,000 capital
P’sshareofS’sshare
premium
P’s share of S’s
retained earnings
at acquisition 80,000
94,000
230,000 230,000
Balance b/d 94,000
This is only shown for background information. Do not use a “T account” but use
a schedule as previously shown.

Financial reporting
4.3 Calculating NCI

The NCI’s share of net assets of S is constructed by transferring in their share of
each of S’s equity balances at the date of consolidation into an NCI account.
Illustration: Double entry to calculate NCI

Debit Credit
Share capital of S 10,000
Non-controlling interest 10,000
Share premium of S 4,000


Non-controlling interest (20% of 125,000) 25,000
Being: Transfer of NCI’s share of S’s share capital, share premium

and retained earnings to the non-controlling interest account
The balance on this account is the non-controlling interest
Example (continued): NCI account
N N
4) NCI’s share of S’s
share capital
(20% of 50,000) 10,000
5) NCI’s share of S’s
share premium
(20% of 20,000) 4,000
6)NCI’sshareofS’s
retainedearnings
Balance b/d 39,000 (20% of125,000) 25,000
39,000 39,000
Balance b/d 39,000

4.4 Calculating consolidated retained earnings

P’s share of S’s retained earnings since the date of acquisition is credited to the
P’s retained earnings account.
Debit Credit
P’s retained earnings 20,000
Being: Transfer of P’s share of post-acquisition profits of S into

retained earnings. (80% of (125,000 –100,000))
The balance on this account is the consolidated retained earnings.
Example (continued): Consolidated retained earnings account

Retained earnings
N N
P’s balance 440,000
P’s share of S’s 20,000
Balance b/d 460,000

460,000 460,000
Balance b/d 460,000

Financial reporting
4.5 Tutorial note

The balances on S’s share capital, share premium and retained earnings have all
been removed elsewhere.
Example (continued): Other accounts

Share capital (of S)
N N
P’s share at acquisition
(to costofcontrol) 40,000 Balanceb/d 50,000
S’sshare(toNCI) 10,000
50,000 50,000
Share premium (of S)

N N
(to costofcontrol) 16,000 Balanceb/d 20,000
S’sshare(toNCI) 4,000
20,000 20,000
Retained earnings (of S)

N N
(to cost of control) 80,000 Balance b/d 125,000
P’s share since
acquisition
(consolidated retained
profits) 20,000
S’s share (to NCI) 25,000
125,000 125,000

5 CHAPTER REVIEW
Describe the concept of a group as a single economic unit
Define using simple examples subsidiary, parent and control
Describe situations when control is presumed toexist
Identify and describe the circumstances in which an entity is required to prepare
and present consolidated financial statements
Prepare basic a consolidated statement of financial position including the
calculation of goodwill, non-controlling interest and consolidated post
acquisition reserves

Solutions 1
a) Goodwill N
Non-controlling interest at acquisition (40 % of 800,000) 320,000
1,086,000
Net assets at acquisition (800,000)
286,000
b) Net assets summary
At date of
acquisition
Share capital 500,000
Net assets 1,250,000
Goodwill N
Cost of investment 1,000,000
Non-controlling interest at acquisition (45 % of 1,250,000) 562,500
1,562,500
Net assets at acquisition (1,250,000)
312,500
C) Net assets summary

At date of
acquisition
Revaluation reserve 120,000
Net assets 518,000
Goodwill N
Non-controlling interest at acquisition (10 % of 518,000) 51,800
1,801,800
1,283,800

Solution (continued) 1
d) Net assets summary
At date of
acquisition
Goodwill N
Non-controlling interest at acquisition (60 % of 1,250,000) 750,000
1,750,000
500,000
Solutions 2
a) Goodwill N
Non-controlling interest at acquisition (given) 350,000
1,116,000
316,000
b) Net assets summary

At date of
acquisition
Goodwill N
1,600,000
350,000

Financial reporting
Solutions (continued) 2
c) Net assets summary
At date of
acquisition
Revaluation reserve 120,000
Net assets 518,000
Goodwill N
1,810,000
1,292,000
Solution
Assets N
Goodwill (W3) 345,000
Other assets (500 + 350) 850,000
Total assets 1,195,000
Equity
Consolidated retained earnings (W4) 685,000
785,000
Non-controlling interest (W2) 60,000
845,000
Total equity and liabilities 1,195,000

Workings:
W1 Net assets summary
Net assets 200,000* 150,000
W2 Non-controlling interest N
(30% u150,000 (W1)) 45,000
NCI’s share of the post-acquisition retained earnings o
fS (30% of 50,000(W1)) 15,000
Alternative working
consolidation (30% u 200,000*) 60,000
W3 Goodwill N
Non-controlling interest at acquisition (see W2) 45,000
495,000
Net assets at acquisition (W1) (150,000)
345,000
W4 Consolidated retained profits: N

P’sshare of the post-acquisition retained earnings of
S (70% of 50,000(W1)) 35,000
685,000

Financial reporting
Solution 4
P Group: Consolidated statement of financial position at 31 December 20X1
Assets N
Other assets (500 + 350) 850,000
Equity
Consolidated retained earnings (W4) 685,000
785,000
875,000
Workings:
Net assets 200,000* 150,000
Fair value of NCI at the date of acquisition 75,000
NCI’s share of the post-acquisition retained earnings of S
(30% of 50,000 (W1)) 15,000
W3 Goodwill N
525,000
Net assets at acquisition (W1) (150,000)
375,000

W4 Consolidated retained profits: All of P’s N
retained earnings 650,000
P’s share of the post-acquisition retained earnings of S (70%
of 50,000(W1))
35,000
685,000

19
Skills level
Financial Reporting
CHAPTER
111
Consolidated accounts: Statements
of financial position-Complications
Contents
Possible complications: Before consolidation
Possible complications: During consolidation
9
Possible complications: After consolidation
Chapter review
119
Financial reporting
INTRODUCTION
Aim
principles.
Detailed syllabus
a Explain the concept of group especially a simple group and the objectives of
preparing group financial statements.
C Calculate non-controlling interest using alternative methods and effect
simple group.

b Prepare and present statement of profit or loss and other comprehensive
income of a simple group (one subsidiary and an associate), in accordance
with the provisions of relevant standards (IAS 1, IAS 28, IFRS 3 and IFRS
10).
c Prepare and present statement of cashflows of a simple group (one
subsidiary and an associate), in accordance with the provisions of IAS 7.
d Discuss management disclosures, analysis and commentaries on financial

statements.
Exam context
This chapter explains further adjustments that might be necessary during the process of
consolidation.
„ Account for acquisition relatedcosts
„ Incorporate straightforward fair value adjustments into a consolidation
„ Account for a mid-year acquisition of a subsidiary
„ Eliminate unrealised profit on transactions between a parent company and its
subsidiary
„ Account forgoodwill
„ Account for gain on a bargain purchase (negative goodwill)
1 POSSIBLE COMPLICATIONS: BEFORE CONSOLIDATION
Acquisition-related costs
Acquired intangible assets
Fair value exercise at acquisition
1.1 Acquisition-related costs

Acquisition-related costs are costs the acquirer incurs to effect a business
combination. They include advisory, legal, accounting, valuation and other
professional or consulting fees.
These costs are not capitalised as part of the cost of acquisition but expensed in
the periods in which they are incurred. (This is different rule to that which applies
to the purchase of property, plant and equipment or intangibles).
A question may incorrectly capitalise the costs. You would have to correct this
before consolidating.
1.2 Acquired intangible assets

A question might provide information about an unrecognised asset of the
subsidiary. You would have to include the asset in the subsidiary’s financial
statements before consolidating them.
Reason
Goodwill is recognised by the acquirer as an asset from the acquisition date.
It is initially measured as the difference between:
‰ the cost of the acquisition plus the non-controlling interest; and
‰ the net of the acquisition date amounts of identifiable assets acquired and
liabilities assumed (measured in accordance with IFRS 3).
When a company acquires a subsidiary, it may identify intangible assets of the
acquired subsidiary, which are not included in the subsidiary’s statement of
financial position. If these assets are separately identifiable and can be measured
reliably, they should be included in the consolidated statement of financial position
as intangible assets and accounted for assuch.

This can result in the recognition of assets and liabilities not previously
recognised by the acquiree.
Illustration: Fair value adjustment

If a company bought 100% of the Coca-Cola Corporation they would be buying alot of
assets but part (perhaps the largest part) of the purchase consideration would be to buy
the Coca Colabrand.
Coca Cola does not recognise its own brand in its own financial statements because
companies are not allowed to recognised internally generated brands.
However, as far as the company buying the Coca-Cola Corporation is concerned the
brand is a purchased asset. It would be recognised in the consolidated financial
statements and would be taken into account in the goodwill calculation.

Financial reporting
Example: Fair value adjustment (non-depreciable asset)

P bought 80% of S 2 years ago.
At the date of acquisition S’s retained earnings stood at N600,000. The fair value of
its net assets was not materially different from the book value except for the
fact that it had a brand which was not recognized in S’s accounts. This had
afair value of 100,000 at this date and an estimated useful life of 20 years.
follows:
P S
N N
PP and E 1,800,000 1,000,000
Investment in S 1,000,000
Other assets 400,000 300,000
3,200,000 1,300,000

Retained earnings 2,900,000 1,000,000
Liabilities 200,000 200,000
3,200,000 1,300,000

December 20X1
N
Assets
Brand (see working) 90,000
Property, plant and equipment (1,800 + 1000) 2,800,000
Other assets (400 + 300) 700,000
Equity
Consolidated retained earnings (see working) 3,212,000
3,312,000
3,550,000

Chapter 19: Consolidated accounts: Statements of financial position - Complications
Example (continued):
Net assets summary of S

At date of At date of Post
consolidation acquisition acqn
Retained earnings
Given in the question 1,000,000 600,000
Extra depreciation on
brand
(100,000 × 2 years/20 years) (10,000) –
990,000 600,000 390,000
Consolidation reserve on
recognition of the brand 100,000 100,000
Net assets 1,190,000 800,000
(20% u800,000) 160,000
NCI’s share of the post-acquisition retained earnings
of S (20% of 390,000(see above)) 78,000
Goodwill N
Non-controlling interest at acquisition (20% u800,000) 160,000
1,160,000
360,000

All of P’s retained earnings 2,900,000
P’s shareofthepost-acquisitionretainedearningsofS
(80% of 390,000 (seeabove)) 312,000
3,212,000
Brand N
On initial recognition 100,000
Depreciation since acquisition (100,000 × 2 years/20 years) (10,000)
90,000

Financial reporting
1.3 Fair value exercise at acquisition

A question might provide information about the fair value of a subsidiary’s assets
at the date of acquisition. You might have to revalue the assets in the subsidiary’s
financial statements before consolidating them.
Reason
Goodwill is recognised by the acquirer as an asset from the acquisition date.
It is initially measured as the difference between:
‰ the cost of the acquisition plus the non-controlling interest; and
‰ the net of the acquisition date amounts of identifiable assets acquired and
liabilities assumed (measured in accordance with IFRS 3).
IFRS 3 requires that most assets and liabilities be measured at their fair value.

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.
IFRS 13 para 9
In every example so far it has been assumed that the fair value of the assets and
liabilities of the subsidiary were the same as their book value as at the date of
acquisition. In practice this will not be the case.
In other cases a question will include information about the fair value of an asset
or assets as at the date of acquisition.
The net assets of a newly acquired business are subject to a fair valuation
exercise.
Where the subsidiary has not reflected fair values at acquisition in its accounts,
this must be done before consolidating. Note that this is almost always the case
Revaluation upwards:
The asset is revalued in the consolidation working papers (not in the general
ledger of the subsidiary). The other side of the entry is taken to a fair value
reserve as at the date of acquisition. This will appear in the net assets working
and therefore become part of the goodwill calculation.
The reserve is also included in the net assets working at the reporting date if the
asset is still owned by the subsidiary.
If a depreciable asset is revalued the post-acquisition depreciation must be
adjusted to take account of the change in the value of the asset being
depreciated.
Revaluation downwards
Write off the amount to retained earnings in the net assets working (book value
less fair value of net assets at acquisition) at acquisition and at the reporting date
if the asset is still owned.

Example: Fair value adjustment (depreciable asset)

P bought 80% of S 2 years ago.
At the date of acquisition S’s retained earnings stood at N600,000 and the fair value
of its net assets were N1,000,000. This was N300,000 above the book value of the
net assets at this date.
The revaluation was due to an asset that had a remaining useful economic life of
10 years as at the date of acquisition.
follows:
P S
N N
PP and E 1,800,000 1,000,000
Investment in S 1,000,000
Other assets 400,000 300,000
3,200,000 1,300,000

3,200,000 1,300,000

December 20X1
N
Assets
PP and E (see working) 3,040,000
Other assets (400,000 + 300,000) 700,000
Equity
Consolidated retained earnings (see working) 3,172,000
3,272,000
3,540,000

Financial reporting
Example (continued): Net
assets summary of S
Retained earnings
Given in the question 1,000,000 600,000
Extra depreciation on
fair value adjustment
(300 × 2 years/10 years) –
see explanation on
next page (60,000) –
940,000 600,000 340,000
Fair value reserve 300,000 300,000
Net assets 1,340,000 1,000,000
(20% u1,000) 200,000
of S (20% of 340 (seea bove)) 68,000
Goodwill N
1,200,000
Net assets at acquisition (see above) (1,000,000)
200,000

P’s share of the post-acquisition retained earnings of
S (80% of 340 (see above)) 272,000
3,172,000

Example (continued): Net assets summary of S

Property plant and equipment N’000
Parent’s 1,800
Subsidiary’s
Given in question 1,000
Fair value adjustment 300
Extra depreciation on fair value
adjustment (300 × 2 years/10years) (60)
1,240
To statement of financial position 3,040
Explanation of extra depreciation

If a depreciable asset is revalued (which is usually the case) the post-acquisition
depreciation must be adjusted to take account of the change in the value of the
asset being depreciated.
In this example, two years ago the subsidiary had an asset which had a fair value
N300,000 greater than its book value. This valuation was not recordedinthe
financial statements of the subsidiary so the subsidiary’s figures need to be
retrospectively adjusted, for the purposes of consolidation, at each yearend.
Depreciation of an asset is based on its carrying amount. Depreciation of an asset
increases when it is revalued. Therefore,the extra depreciation necessary as a
result of the fairvalue adjustment is N 30,000 per annum (N 00,000/10years)
.
The acquisition was 2years ago so extra depreciation of N60,000(N30,000 u2
years) must be recognised retrospectively.

Financial reporting
Practice question
for N1
N
Also, at the date of acquisition S held an item of plant with a carrying amount
of 250,000 less than its fair value. This asset had a remaining useful life of 10
years as from that date.
It is P’s policy to recognize non-controlling interest at the date of acquisition as
a proportionate share of net assets.
The statements of financial position of P and S as at 31 December 20X1 were
as follows:
P(N) S(N)
Assets:
Investment in S, at cost 1,000,000 -
Other non-current assets 400,000 200,000
1,900,000 550,000
Equity
Retained earnings 1,600,000 300,000
1,700,000 400,000
1,900,000 550,000

31 December 20X1.

2 POSSIBLE COMPLICATIONS: DURING CONSOLIDATION
Mid-year acquisitions
Types of intra-group transaction
The need to eliminate intra-group transactions on consolidation
Unrealised profit –Inventory
Unrealised profit – Transfers of non-current assets
2.1 Mid-year acquisitions

Goodwill is measured at the date of acquisition of the subsidiary.
H may not acquire S at the start or end of a year. If S is acquired mid-year, it is
necessary to calculate the net assets at date of acquisition in order to calculate
goodwill, non-controlling interest and consolidated retained earnings.
This usually involves calculating the subsidiary’s retained earnings at the date of
acquisition. The profits of the subsidiary are assumed to accrue evenly over time
unless there is information to the contrary.
N
Retained earnings at the start of the year
Retained earnings for the year up to the date of acquisition
Retained earnings at the date of acquisition

Financial reporting
Example: Mid-year acquisition

P bought 70% of S on 31st March this year.
for N
follows:
P S
N N
PP and E 100,000 20,000
Investment in S 50,000
Other assets 30,000 12,000
180,000 32,000

180,000 32,000

20X1
N
PP and E (100,000 + 20,000) 120,000
Other assets (30,000 + 12,000) 42,000
Equity
176,300
185,600

Net assets summary of
S At date of At date of
Retained earnings
Given in the question 30,000
See working below 21,000
30,000 21,000 9,000
Net assets 31,000 22,000
Retained earnings of the subsidiary as at the date of acquisition

N
Retained earnings at the start of the year
Retained earnings at the end of the year 30,000)
Less: profit for the year (12,000)
18,000
Profit from the start of the year to the date of acquisition
(3/12 u12,000) 3,000
(30% u22,000) 6,600
of S (30% of 9,000 (see above)) 2,700
Goodwill N
56,600
34,600

S (70% of 9,000 (see above)) 6,300
166,300

Financial reporting
2.2 Types of intra-group transaction

In many groups, business and financial transactions take place between entities
within the group. These ‘intra-group’ transactions might be:
‰ The sale of goods or services between the parent and a subsidiary, or
between two subsidiaries in the group
‰ Transfers of non-current assets between the parent and a subsidiary, or
between two subsidiaries in the group
‰ The payment of dividends by a subsidiary to the parent (or by one
subsidiary to another subsidiary)
‰ Loans by one entity in the group to another, and the payment of interest on
intra-group loans.
2.3 The need to eliminate intra-group transactions on consolidation

Intra-group transactions should be eliminated on consolidation. In other words,
the effects of intra-group transactions must be removed from the financial
statements on consolidation.
The purpose of consolidated accounts is to show the financial position and the
financial performance of the group as a whole, as if it is a single operating unit. If
intra-group transactions are included in the consolidated financial statements, the
statements will show too many assets, liabilities, income and expenses for the
group as a single operating unit.
The consolidated financial statements represent the financial position and
performance of a group of companies as if they are a single economic entity. A
single economic entity cannot owe itself money!
IFRS 10 therefore requires that:
‰ Intra-group balances and transactions, including income, expenses and
dividends, must be eliminated infull.
‰ Profits or losses resulting from intra-group transactions that are recognised
in inventory or non-current assets must be eliminated infull.
Example: Elimination of intra-group transactions on consolidation

H owns 80% of S. H sells goods to S.
financial
position
P S Dr Cr
From S 1,000 1,000
To H 1,000 1,000
The above adjustment is simply a cancellation of the inter-company receivable in

one group member’s statement of financial position against the inter-company
payable in another group member’s statement of financial position.
Items in transit
At the year-end current accounts may not agree, owing to the existence of in-
transit items such as goods or cash.
The usual convention followed is to follow the item through to its ultimate
destination and adjust the books of the ultimate recipient.
2.4 Unrealised profit – Inventory

Inter-company balances are cancelled on consolidation. The main reason for these
arising is inter company (or intra group) trading. The other example you will come
across is inter-company transfers of non-current assets.
If a member of a group sells inventory to another member of the group and that
inventory is still held by the buying company at the year-end:
‰ The company that made the sale will show profit in its ownaccounts.
x This is fine from the individual company viewpoint but the profit has not
been realised by the group.
‰ The company that made the purchase will record the inventory at cost to
itself.
x This is fine from the individual company view but consolidation of this value
will result in the inclusion in the financial statements of a figure which
is not at cost to the group.
IFRS 10 requires that the unrealised profit be removed in full from the closing
inventory valuation. It gives no further guidance on how this should be done.
This is an inventory valuation adjustment and can be processed in the

consolidated financial statements.
Illustration: Unrealised profit double entry
Debit Credit
Closing inventory – Statement of comprehensive income X
Closing inventory – Statement of financial position X
There is a complication to think about. If S is the selling company the purpose of

the above adjustment is to reduce the profit of the subsidiary because there is
unrealised profit on the inter-company transaction and reduce the inventory held
by P as it is not at cost to the group.
If the profit of the subsidiary is being reduced then NCI should share in that
reduction. This implies a second journal as follows:
Debit Credit
NCI in the statement of financial position X
NCI in the statement of comprehensive income X
With their share of the adjustment
The two journals can be combined as follows to produce a composite adjustment

in questions which only require the preparation of the statement of financial
position.

Debit Credit
NCI in the statement of financial position X
Example: Unrealised profit

P bought 80% of S, 2 years ago. At the date of acquisition S’s retained earnings
N
for N N
still held 40% of these goods at the year end.
follows: P S
N N
PP and E 100,000 41,000
Investment in S 50,000
Other assets 110,000 50,000
260,000 91,000

260,000 91,000

20X1
Assets N
PP and E (100,000 + 41,000) 141,000
Other assets (see working) 156,800
Equity
279,440
296,000

Financial reporting
Example (continued): Net
assets summary of S
At date of At date of Post acqn
consolidation acquisition
Retained earnings
Given in the question 56,000 16,000 40,000
Net assets 82,800 46,000
Unrealised profit
N
Total profit on transaction 8,000
Inventory held at year end (therefore the profit on this
is unrealised by the group) 40%
Adjustment 3,200
Double entry in consolidated financial statements Dr Cr

Consolidated retained earnings (80% u3,200) 2,560
NCI – Statement of financial position (20% u3,200) 640
Closing inventory – Statement of financial position 3,200
(20% u46,000) 9,200
of S (20% of 40,000 (see above)) 8,000
NCI share of unrealised profit adjustment (640)
Goodwill N
Non-controlling interest at acquisition (20% u 46,000) 9,200
59,200
Recoverable amount of goodwill (given) 13,200

Example (continued)
S (80% of 40,000 (see above)) 32,000
Unrealised profit adjustment (2,560)
229,440
Practice question
for N
N
N
It is P’s policy to recognise non-controlling interest at the date of acquisition as a
proportionate share of net assets.
for N on cost.
S had sold some of this inventory to third parties but still held
for N em
The statements of financial position of P and S as at 31 December 20X1 were as
follows:
P(N) S(N)
Assets:
Investment in S, at cost 2,000,000 -
Other non-current assets 650,000 826,000
Current assets
Inventory 100,000 80,000
Amount owed by S 6,000 na
Other current assets 374,000 320,000
480,000 400,000
3,130,000 1,226,000
Equity
Current liabilities
Amount owed to P na 6,000
Other current liabilities 240,000 120,000
440,000 126,000
3,130,000 1,226,000
Prepare a consolidated statement of financial position as at 31

December 20X1.

Financial reporting
2.5 Unrealised profit–Transfers of non-current assets

One member of a group may sell a non-current asset to another member of the
group.
The company making the sale will recognise a profit or loss on disposal.
The company buying the asset will include the asset at purchase cost in its own
accounts and depreciation will be based on that amount. This cost will be
different to cost to the group.
As far as the group is concerned no transfer has occurred. The group accounts
must reflect non-current assets at the amount they would have been stated at
had the transfer not been made.
Summary of adjustments:
‰ Remove profit from the financial statements of the company that made the
sale; and
‰ Correct the depreciation charge in the financial statements of the company
that made the purchase.
These two adjustments establish the transferred asset at its cost less
accumulated depreciation to the group.
The double entry is shared to the NCI as appropriate in the consolidated
statement of financial position.
‰ If the sale was to S the NCI would share the depreciation adjustment.
‰ If the sale was from S to H the NCI would share the profit adjustment.
This is best seen with an illustration.

Example: Unrealised profit on transfer of non-current assets

H owns 80% of S.
There was a transfer of an asset within the group for N15,000 on1 January 20X3.
The original cost to H was N20,000 and the accumulated depreciation at the date
of transfer was N8,000.
Both companies depreciate such assets at 20% per year on cost to the
company, recognising a full year’s depreciation in the year of purchase and
none in the year of sale.
Figures in the Figures ifno Adjustment
accounts transfer had required
been made
Against S’s figures:
Cost 15,000 20,000 5,000 Dr
Accumulated depreciation (3,000) (12,000) 9,000 Cr
12,000 8,000 4,000 Cr
Charge for the year 3,000 4,000 1,000 Dr
Against P’s figures:

Profit on disposal
Proceeds 15,000
Carrying amount at
disposal (20,000 – 8,000) (12,000)
3,000 nil
If the transfer was from H toS–Full journal

Consolidated financial statements Dr Cr
Income statement (profit on disposal) 3,000
Income statement (depreciation) 1,000
Non-current asset 4,000
NCI in the statement of financial position 200

NCI in the statement ofcomprehensiveincome 200
Being the NCI share of the depreciation adjustment (20% u1,000)
Composite journal if just preparing the

consolidated statement of financial position Dr Cr
Consolidated retained earnings 3,800

Financial reporting
If the transfer was from S to H – Full journal

Consolidated financial statements Dr Cr
Income statement (profit on disposal) 3,000
Income statement (depreciation) 1,000
Composite journal if just preparing the
consolidated statement of financial position Dr Cr
3 POSSIBLE COMPLICATIONS: AFTER CONSOLIDATION

Negative goodwill and bargain purchases
3.1 Accounting for goodwill

Goodwill is carried as an asset. It is not depreciated or amortised but instead it is
subject to an annual impairment review.
This means that the recoverable amount of goodwill must be estimated on an
annual basis. If the recoverable amount is less than the carrying amount, the
goodwill is written down to the recoverable amount.
The amount of the impairment is included as a charge against profit in the
consolidated statement of comprehensive income.
Example: Goodwill impairment

N
The values for assets and liabilities in the statement of financial position for S
represent fair values.
A review of goodwill at 31 December 20X1 found that goodwill had been
N
The statements of financial position of a parent company P and its subsidiary
Sat 31 December 20X1 are as follows:
P(N) S(N)
Non-current assets:
Property, plant and equipment 408,000 100,000
670,000 140,000
Equity
600,000 130,000
Bank loan 70,000 10,000
670,000 140,000

P Group: Consolidated statement of financial position at 31December 20X1
Assets
Property, plant and equipment (508 + 100) 508,000
Current assets (120,000 + 40,000) 160,000
Equity
617,000
643,000

Net assets summary of
S At date of
Consolidation Acquisition Post acqn
Net assets 130,000 90,000
(20% u90,000) 18,000
of S (20% of 40,000 (see above)) 8,000
Goodwill N
Non-controlling interest at acquisition (20% u 90,000) 18,000
160,000
70,000
Write down of goodwill (balancing figure) (15,000)
Recoverable amount of goodwill (given) 55,000

S (80% of 40,000 (see above)) 32,000
Write down of goodwill (see goodwill working) (15,000)
417,000

Financial reporting
3.2 Negative goodwill and bargain purchases

A bargain purchase is a business combination in which the calculation of goodwill
leads to a negative figure.
When this happens the acquirer must then review the procedures used to
measure the amounts recognised at the acquisition date for all of the following:
‰ The identifiable assets acquired and liabilities assumed;
‰ The non-controlling interest in the acquiree (if any); and
‰ The consideration transferred.
Any amount remaining after applying the above requirements is recognised as a
gain in profit or loss on the acquisition date.
This means that in most cases when a bargain purchase occurs, the ‘negative
goodwill’ should be added to the consolidated profit for the group for the year.
4 CHAPTER REVIEW
Account for acquisition related costs
Incorporate straightforward fair value adjustments into a consolidation
Account for a mid-year acquisition of a subsidiary
Eliminate unrealised profit on transactions between a parent company and its
subsidiary
Account for goodwill
Account for gain on a bargain purchase (negative goodwill)

Financial reporting

Solution 1
Assets N
Other non-current assets (400 + (200 + 250 –25)) 825,000
Other assets (500 + 350) 850,000
Equity
Consolidated retained earnings (W4) 1,757,500
1,857,500
2,045,000
Workings:
Sharecapital 100,000 100,000

Retained earnings
Given in the question 300,000 50,000
Extra depreciation on fair
value adjustment (250 × 1
years/10 years) (25,000) –
275,000 50,000 225,000
Net assets 625,000 400,000
(30% u400) 120,000
of S (30% of 225(W1)) 67,500

W3 Goodwill N
Non-controlling interest at acquisition (W2) 120,000
1,120,000
720,000

S (70% of 225(W1)) 157,500
1,757,500
Solution
2
Assets N
Goodwill (W3) 1,199,000
Other non-current assets (650 + (826 + 500) 1,976,000
Current assets:
Inventory (100 + 80 –2.5) 177,500
Other current assets (374 + 320) 694,000
Equity
Consolidated retained earnings (W4) 2,746,500
2,846,500
3,486,500

Financial reporting
Workings:
Retained earnings 1,050,000 785,000 265,000
Net assets 1,600,000 1,335,000
acquisition (40% u1,335 (W1)) 534,000
of S (40% of 265(W1)) 106,000
W3 Goodwill N
Non-controlling interest at acquisition (W2) 534,000
2,534,000
Net assets at acquisition (see above) (1,335,000)
1,199,000

Unrealised profit (W5) (2,500)
S (60% of 265(W1)) 159,000
2,746,500
W5 Unrealised profit N
Inventory held at sale value 12,500
Cost (100/125) (10,000)
Mark-up (25% of cost or 25/125 of sale price) 2,500
Double entry in consolidated financial statements Dr Cr

Closing inventory – statement of financial position 2,500
NCI not affected as sale is from P to S

CHAPTER
Contents
Consolidated statement of profit or loss and other
Complications
Chapter review

Financial reporting
INTRODUCTION
Aim
principles.
Detailed syllabus
preparation and presentation of financial statements of simple group –IAS
28, IFRS 3 and IFRS 10), including the use of fair value for non- controlling
interest.
c Calculate non-controlling interest using alternative methods andeffect
simplegroup.
with the provisions of relevant standards (IAS 1, IAS 27, IAS 28, IFRS 3 and
IFRS 10).
Exam context
This chapter explains the consolidation of statements of comprehensive income.

„ Prepare a basic consolidated statement of profit or loss
„ Eliminate the results of inter-company transactions on consolidation
„ Eliminate unrealised profit on consolidation
„ Incorporate straight forward fair value adjustments during consolidation

Chapter 20: Consolidated accounts: Statements of comprehensive income
1 CONSOLIDATED STATEMENT OF PROFIT OR LOSS AND

OTHER COMPREHENSIVE INCOME
Consolidated income statement: the basic rules

Pre- and post-acquisition profits
1.1 Consolidated income statement: the basic rules

The main problems with preparing a consolidated statement of profit or loss and
other comprehensive income relate to reporting profit or loss for the period, and
this section therefore focuses on profit or loss items.
A consolidated statement of profit or loss brings together the sales revenue,
income and expenses of the parent and the sales revenue, income and expenses
of its subsidiaries.
All items of income and expense in the consolidated statement of profit or loss
are a straight cross cast of equivalent items in the individual financial statements
of the members of the group.
Consolidated financial statements must also disclose the profit or loss for the
period and the total comprehensive income for the period attributable to:
▪ Owners of the parent company; and
▪ Non-controlling interests.
The figure for NCI is simply their share of the subsidiary’s profit for the year that
has been included in the consolidated statement of profit or loss.
The amounts attributable to the owners of the parent and the non-controlling
interest are shown as a metric (small table) immediately below the statement of
profit or loss and other comprehensive income.
Illustration:
Total comprehensive income attributable to: N
Owner soft he parent (balancing figure)
Non-controlling interests (x% of y)
Where: x% is the NCI ownership interest

Y is the subsidiary’s profit for the year that has been included in
the consolidated statement of profit or loss

Financial reporting
Example:
Entity P bought 80% of S several years ago.
The income statements for the year to 31 December 20X1 are as follows.
P S
N N
Revenue 500,000 250,000
Cost of sales (200,000) (80,000)
Gross profit 300,000 170,000
Other income 25,000 6,000
Other expenses (30,000) (18,000)
Finance costs (15,000) (8,000)
Profit before tax 120,000 40,000
Income tax expense (45,000) (16,000)
Profit for the period 75,000 24,000
A consolidated statement of profit or loss can be prepared as follows:
P S Consolidated
N N N
Revenue 500,000 250,000 750,000
Cost of sales (200,000) (80,000) (280,000)
Gross profit 300,000 170,000 470,000
Other income 25,000 6,000 31,000
Distribution costs (70,000) (60,000) (130,000)
Administrative
expenses (90,000) (50,000) (140,000)
Other expenses (30,000) (18,000) (48,000)
Finance costs (15,000) (8,000) (23,000)
Income tax expense (45,000) (16,000) (61,000)

Profit for the period 75,000 24,000 99,000
Total comprehensive income attributable to:

Owners of the parent (balancing figure) 94,200
Non-controlling interests (20% of 24,000) 4,800
99,000

1.2 Pre-and post-acquisition profits

Only post acquisition profits are consolidated. When a parent acquires a
subsidiary during a financial year, the profits of the subsidiary have to be divided
into pre-acquisition and post-acquisition profits.
Example:
Entity P acquired 80% of S on 1 October 20X1.
The acquisition date was 1 October. This means that only 3/12 of the ubsidiary’s
profit for the year is post-acquisition profit.
The income statements for the year to 31 December 20X1 are as follows:
P S
N N
Revenue 400,000 260,000
Cost of sales (200,000) (60,000)
Gross profit 200,000 200,000
Other income 20,000 -
Income tax expense (30,000) (15,000)
Profit for the period 50,000 60,000
A consolidated statement of profit or loss can be prepared as follows:
P S (3/12) Consolidated
N N N
Revenue 400,000 5,000 465,000
Cost of sales (200,000) (15,000) (215,000)
Gross profit 200,000 50,000 250,000
Other income 20,000 – 20,000
Distribution costs (50,000) (7,500) (57,500)
Administrative
expenses (90,000) (23,750) (113,750)
Income tax expense (30,000) (3,750) (33,750)
Profit for the period 50,000 15,000 65,000
Total comprehensive income attributable to:

Owners of the parent (balancing figure) 62,000
Non-controlling interests (20% of 15,000) 3,000
65,000

Financial reporting
2 COMPLICATIONS
Inter-company items
Fair value adjustments
Impairment of goodwill and consolidated profit
2.1 Inter-company items

Consolidated income statements are prepared by combining the information
given in the income statements of the individual companies.
It is usually necessary to make adjustments to eliminate the results of inter-
company trading. This includes adjustments to cancel out inter-company trading
balances and unrealised profit.
Inter-company trading
Inter-company trading will be included in revenue of one group company and
purchases of another. These are cancelled on consolidation.
Illustration:
Debit Credit
Revenue X
Cost of sales (actually purchases within cost of sales) X

Example:
P acquired 80% of S 3 years ago.
for N
By the year-end S had sold all of the goods bought from P to customers.
Extracts of the income statements for the year to 31 December 20X1 are as follows.
P S
N N
Revenue 800,000 420,000
Cost of sales (300,000) (220,000
Gross profit 500,000 200,000
The adjustment in respect of inter-company trading can be shown as follows:
P S Dr Cr Consol.
N N N N N
Revenue (000) (000) (000) (000) (000)
800 420 (50) 1,170
Cost of sales (300) (220) 50 (470)
Gross profit 500 200 (50) 50 700
The adjustment has no effect on grossprofit.
Unrealised profits on trading

If any items sold by one group company to another are included in inventory (i.e.,
have not been sold on outside the group by the year end), their value must be
adjusted to lower of cost and net realisable value from the group viewpoint (as for
the consolidated statement of financial position).
This is an inventory valuation adjustment made in the consolidated financial
statements.
Illustration:
Debit Credit
Closing inventory – Statement of profit or loss X
The adjustment in the statement of profit or loss reduces gross profit and hence
profit for the year. The NCI share in this reduced figure and the balance is added
to retained earnings. Thus, the adjustment is shared between both ownership
interests.

Financial reporting
Example:
During the year P sold goods to S for N50,000 at a mark-up of 25% on cost. This
means that the cost of the goods to P was N40,000 (100/125 u N50,000) and P
made a profit of N10,000000 (25/125 u N50,000) on the sale to S.
At the year-end S still had 30% of the goods in inventory.
This means that S still held goods which it had purchased from P for N15,000 at a
profit to P of N3,000. The N3,000 is unrealized by the group as at the year-end.
Extracts of the income statements for the year to 31 December 20X1 are as
follows.
P(N) S(N)
Revenue 800,000 420,000
Cost of sales (300,000) (220,000
Gross profit 500,000 200,000
The adjustments in respect of inter-company trading1 and

unrealised profit2 can be shown as follows:
P S Dr Cr Consol.
N N N N N
Revenue (000) (000) (000) (000) (000)
800 420 (50)1 1,170
Cost of sales (300) (220) (3)2 501 (473)
Gross profit 500 200 (53) 50 697
The adjustment in respect of inter-company trading1 has no effect on gross

profit.
The adjustment in respect of and unrealised profit2 reduces gross profit.

If the sale is from S to P the unrealised profit adjustment must be shared with the
NCI.
Example:
for N
N N
profi N N
At the year-end P still had a third of the goods in inventory.
for N
N N
N N
follows.
P(N) S(N)
Revenue 800,000 420,000
Cost of sales (300,000) (220,000
Gross profit 500,000 200,000
Expenses (173,000) (123,000)
The adjustments in respect of inter-company trading and

unrealised profit can be shown as follows:
Workings
P S Dr Cr Consol.
N N N N N
Revenue (000) (000) (000) (000) (000)
800 420 (50)1 1,170
Cost of sales (300) (220) (3)2 501 (473)
Gross profit 500 200 (53) 50 697
Expenses (173) (123) (296)
Profit 427 77 (53) 50 401
The adjustment in respect of and unrealised profit reduces gross profit

and is shared with the NCI.

Owners of the parent (balancing figure) (000)
386.2
Non-controlling interests (20% u77,000) –600) 14.8
401.0

Financial reporting
Inter-company management fees and interest

All other inter-company amounts must also be cancelled.
Where a group company charges another group company, management
fees/interest, there is no external group income or external group expense, and
they are cancelled one against the other like inter-company sales and cost of
sales.
Illustration:
Debit Credit
Income (management fees) X
Expense (management charges) X
Example:
Other income in P’s statement of profit or loss includes an inter-company
N in admini
expenses.
follows:
P S
N N
Revenue 800,000 420,000
Cost of sales (300,000) (220,000)
Gross profit 500,000 200,000
Other income 12,000 2,000

Example continued
The adjustments in respect of inter-company management charge can be
shown as follows:
P S Dr Cr Consol.
N N N N N
Revenue (000) (000) (000) (000) (000)
800 420 1,220
Cost of sales (300) (220) (520)
Gross profit 500 200 700
Administrative
expenses (100) (90) 5 (185)
Distribution
costs (85) (75) (160)
Other income 12 2 (5) 9
Profit before
tax 327 37 364
The adjustment in respect of inter-company management charge has no

effect on gross profit.
Inter-company dividends
The parent may have accounted for dividend income from a subsidiary. This is
cancelled on consolidation.
Dividends received from a subsidiary are ignored in the consolidation of the
statement of profit or loss because the profit out of which they are paid has
already been consolidated.

Financial reporting
2.2 Fair value adjustments

Depreciation is charged on the carrying amount of assets.
If a depreciable asset is revalued on consolidation the depreciation stream that
relates to that asset will also need to be revalued.
This adjustment is carried out in the financial statements of the subsidiary. It will
affect the subsidiary’s profit after tax figure and therefore will affect the NCI.
Example:
N
N N
this this N
in statement this year.
Extracts of the income statements for the year to 31 December 20X1 are as follows:
P S
N N
Revenue 800,000 420,000
Cost of sales (300,000) (220,000)
Gross profit 500,000 200,000
Expenses (173,000) (163,000)
The adjustments in respect of extra depreciation can be shown as follows:
P S Dr Cr Consol.
N N N N N
Revenue (000) (000) (000) (000) (000)
800 420 1,220
Cost of sales (300) (220) (520)
700
Gross profit 500 200 (348)
Expenses (173) (163)
Adjustment (12)
Profit before
tax 327 25
The adjustment in respect of the extra depreciation reduces the profit of S

that is consolidated.

2.3 Impairment of goodwill and consolidated profit

When purchased goodwill is impaired, the impairment does not affect the
individual financial statements of the parent company or the subsidiary. The
effect of the impairment applies exclusively to the consolidated statement of
financial position and the consolidated income statement.
If goodwill is impaired:
‰ It is written down in value in the consolidated statement of financial
position, and
‰ The amount of the write-down is charged as an expense in the
consolidated income statement (normally in administrative expenses).
Example:
N
The annual impairment test on goodwill has shown it to have a recoverable
Amount N write N
follows.
P S
N N
Revenue 800,000 420,000
Cost of sales (300,000) (220,000)
Gross profit 500,000 200,000
Expenses (173,000) (163,000)
The adjustment in respect of inter-company trading1and

unrealised profit2 can be shown as follows:
P S Dr Cr Consol.
N N N N N
Revenue (000) (000) (000) (000) (000)
800 420 1,220
Cost of sales (300) (220) (520)
Gross profit 500 200 700
Expenses (173) (163) (25) (361)
Profit before
tax 327 37 (25) 339
The adjustment in respect of the goodwill reduces the consolidated

profit. (There is no impact on NCI).

Financial reporting
Practicequestion 1
P acquired 80% of S 3 years ago. Goodwill on acquisition was 80,000. The
recoverable amount of goodwill at the year-end was estimated to be 65,000.
This was the first time that the recoverable amount of goodwill had fallen below
the amount at initial recognition.
S sells goods to P. The total sales in the year were 100,000. At the year-end P
retains inventory from S which had cost S 30,000 but was in P’s books at 35,000.
The distribution costs of S include depreciation of an asset which had been
subject to a fair value increase of 100,000 on acquisition. This asset is being
written off on a straight-line basis over 10 years.
The income statements for the year to 31 December 20X1 are as follows:
P S
N N
Revenue (000) (000)
1,000 800
Cost of sales (400) (250)
Gross profit 600 550
Distribution costs (120) (75)
Administrative expenses (80) (20)
400 455
Dividend from S 80 -
Finance cost (25) (15)
Profit before tax 455 440
Tax (45) (40)
Profit for the period 410 400
Prepare the consolidated income statement for the year ended
31 December.

3 CHAPTER REVIEW
Before moving on to the next chapter check that you are able to:
Prepare a basic consolidated statement of profit orloss
Eliminate the results of inter-company transactions on consolidation
Eliminate unrealised profit on consolidation
Incorporate straightforward fair value adjustments during consolidation

Financial reporting
Consolidated statement of profit or loss for the year ended 31 December.
Workings
P S Dr Cr Consol.
N N N N N
Revenue (000) (000) (000) (000) (000)
1,000 800 (100) 1,700
Cost of sales (400) (250) 3(5) 100 (555)
Gross profit 600 550 (105) 100 1,145
Distribution costs (120) (75)
Fair value adjustment 1(10)
(120) (85) (205)

Administrative
expenses (80) (20) 2(15) (115)
400 445
Dividend from S 80 - (80)
Finance cost (25) (15) (40)
Profit before tax 455 430 785
Tax (45) (40) (85)
Profit for the period 410 390 (200) 100 700

Owners of the parent (balancing figure) (000)
633
Non-controlling interests (20% of 390,000) –(20% of 35,000) 77
700
Notes:
1:Extra depreciationon fair value adjustment(100/10years)
2: Goodwillimpairment
3: Unrealised profit

CHAPTER
Contents
IFRS 11: Joint arrangements
IAS 28: Investments in associates and joint ventures
Chapter review

Financial reporting
INTRODUCTION
Aim
principles.
Detailed syllabus
with the provisions of relevant standards (IAS 1, IAS 27, IAS 28, IFRS 3 and
IFRS 10).
Exam context
This chapter explains the accounting rules for associates.

„ Define anassociate
„ Explain equity accounting
„ Measure investment in an associate for inclusion in the statement of financial position
using equity accounting
„ Measure share of profit of an associate for inclusion in the statement of comprehensive
income
„ Account for unrealised profit on transactions between an associate and its parent or a
member of the parent’s group

Chapter 21: Associates and joint ventures
1 IFRS 11: JOINT ARRANGEMENTS
Introduction
Jointarrangements
Types of joint arrangements
1.1 Introduction
A controlling interest in an investee results in an investment (a subsidiary) which
is consolidated.
An interest in the equity shares of another company that gives no influence is
accounted for as follows:
▪ The shares are shown in the statement of financial position as long-term
assets (an investment) and valued in accordance with IAS 39 (IFRS 9); and
▪ Any dividends received for the shares are included in profit or loss for the
year as other income.
Other investments might result in joint control or significant influence. The rules
for accounting for these are given in:
‰ IFRS 11 Joint Arrangements: and
‰ IAS 28 Investments in Associates and Joint ventures.
This session introduces the rules on accounting for joint arrangements.
IFRS 11 is not an examinable document at this level. It is discussed briefly to
provide an introduction to IAS 28.
1.2 Joint arrangements
Definition
A joint arrangement is an arrangement of which two or more parties have joint
control.
Joint control is the contractually agreed sharing of control of an arrangement,
which exists only when decisions about the relevant activities require the
unanimous consent of the parties sharing control.

Financial reporting
1.3 Types of joint arrangements

There are two types of joint arrangement. A joint arrangement is either a joint
operation or a joint venture.
▪ A joint operation is a joint arrangement whereby the parties that have joint
control of the arrangement have rights to the assets, and obligations for the
liabilities, relating to the arrangement. Those parties are called joint
operators.
▪ A joint venture is a joint arrangement where the parties that have joint
control of the arrangement have rights to the net assets of the
arrangement. Those parties are called joint venturers.
A joint venturer must recognise its interest in a joint venture as an investment and
account for it using the equity method in accordance with IAS 28 Investments in
Associates and Joint Ventures unless the entity is exempted from applying the
equity method as specified in that standard.
2 IAS28: INVESTMENTS IN ASSOCIATES AND JOINT VENTURES
Associates and joint ventures

Accounting for associates and joint ventures
Trading with an associate or joint venture
2.1 Associates and joint ventures
Definition
An associate is an entity over which the investor has significant influence.
Significant influence
Significant influence is the power to participate in the financial and operating policy
decisions of the investee but is not control or joint control of those policies.
‰ IAS 28 states that if an entity holds 20% or more of the voting power
(equity) of another entity, it is presumed that significant influence exists,
and the investment should be treated as an associate.
‰ If an entity owns less than 20% of the equity of another entity, the normal
presumption is that significant influence does not exist.
Holding 20% to 50% of the equity of another entity therefore means as a general
rule that significant influence exists, but not control; therefore, the investment is
treated as an associate, provided that it is not a joint venture.
The ‘20% or more’ rule is a general guideline, however, and IAS 28 states more
specifically how significant influence arises. The existence of significant influence
is usually evidenced in one or more of the following ways:
‰ Representation on the board of directors;
‰ Participation in policy-making processes, including participation in decisions
about distributions(dividends);
‰ Material transactions between the two entities;
‰ An interchange of management personnel between the two entities; or
‰ The provision of essential technical information by one entity to the other.

Financial reporting
2.2 Accounting for associates and joint ventures

IAS 28 states that associates and joint ventures must be accounted for using the
equity method.
The equity method is defined as a method of accounting whereby the
investment is initially recognised at cost and adjusted thereafter for the post-
acquisition change in the investor’s share of the investee’s net assets.
The investor’s profit or loss includes its share of the investee’s profit or loss and
the investor’s other comprehensive income includes its share of the investee’s
other comprehensive income.
Statement of financial position: investment in the associate

In the statement of financial position of the reporting entity (the investor), an
investment in an associate is measured at:
N
Cost of investment
Plus/(Minus): Parent’s share of profits(losses)of the
associate (or JV) since acquisition
Plus/(Minus): Parent’s share of OCI of the
associate(orJV) since acquisition
Minusany impairment of the investment
recognised Investment in associate
There is no goodwill-recognised for an investment in an associate.

The accumulated profits of the reporting entity (or the consolidated accumulated
reserves when consolidated accounts are prepared) should include the investor’s
share of the post-acquisition retained profits of the associate (or JV), (minus any
impairment in the value of the investment since acquisition). This completes the
other side of the entry when the investment is remeasured.
Similarly, any other reserve of the reporting entity (or any other consolidated
reserves when consolidated accounts are prepared) should include the investor’s
share of the post-acquisition movement in the reserve of the associate (or JV).
Statement of profit or loss and other comprehensive income

In the statement of profit or loss and other comprehensive income, there should
be separate lines for:
‰ ‘Share of profits of associate (or JV)’ in the profit and loss section of the
statement
‰ ‘Share of other comprehensive income of associate (or JV)’ in the ‘other
comprehensive income’ section of the statement.

Example: Equity method

Entity P acquired 30% of the equity shares in Entity A during Year 1 at a cost of
N147,000 when the fairvalue of the net assets of Entity A was N350,000.
Entity P is able to exercise significant influence over Entity A.
At 31 December Year 5, the net assets of Entity A were N600,000.
In the year to 31 December Year 5, the profits of Entity A after tax were
N80,000.
The figures that must be included to account for the associate in the financial
statements of Entity P for the year to 31 December Year 5 are as follows:
Statement of financial position:
The investment in the associate is as follows:
N
Investment at cost 147,000
Investor’s share of post-acquisition profits of A (W1) 75,000
Investment in the associate 222,000
W1 Retained post-acquisition profits of Entity A N

Net assets of the associate at 31 December Year 5 600,000
Net assets of Entity A at date of acquisition of shares (350,000)
Retained post-acquisition profits of Entity A 250,000
Entity P’s share of A 30%
Entity P’s share of A’s profits since the date of acquisition N75,000
N in profits
N mulated profits N

The share of the associate’s after-tax profit for the year is shown on a separate
line as:
Share of profits of associate(30%×N80,000): N24,000.

Financial reporting
Practice question 1
Entity P acquired 40% of the equity shares in Entity A during Year 1 at a cost
of N128,000 when the fair value of the net assets of Entity A was
N250,000.
Since that time, the investment in the associate has been impaired by
N8,000.
Since acquisition of the investment, there has been no change in the issued
share capital of Entity A, nor in its share premium reserve or revaluation
reserve.
On 31December Year 5, the net assets of Entity A were N400,000.
In the year to 31 December Year 5, the profits of Entity A after tax were
N50,000.
What figures would be included for the associate in the financial statements
of Entity P for the year to 31 December Year 5?
There might be trading between a parent and an associate (or JV). If in addition to
the associate (or JV) the parent holds investments in subsidiaries there might also be
trading between other members of the group and the associate (or JV).
In such cases there might be:
‰ Inter-company balances (amounts owed between the parent (or group) and
the associate (or JV) in either direction); and
‰ Unrealised profit on inter-company transactions.
The accounting rules for dealing with these items for associate (or JVs) are
different from the rules for subsidiaries.
Inter-company balances
Inter-company balances between the members of a group (parent and
subsidiaries) are cancelled out on consolidation.
Inter-company balances between the members of a group (parent and
subsidiaries) and associates (or JVs) are not cancelled out on consolidation. An
associate (or JV) is not a member of the group but is rather an investment made
by the group. This means that it is entirely appropriate that consolidated financial
statements show amounts owed by the external party as an asset and amount
owed to the external party as a liability.
This is also the case if a parent has an associate (or JV) and no subsidiaries. The
parent must equity account for the investment. Once again, it is entirely appropriate
that consolidated financial statements show amounts owed by the external party
as an asset and amount owed to the external party as a liability.

Financial reporting
Unrealised inter-group profit

Unrealised inter-company (intra-group) profit between a parent and a member of
a group must be eliminated in full on consolidation.
For unrealised profit arising on trade between a parent and associate (or JV)
only the parentʼs share of the unrealised profit is eliminated.
IAS 28 does not specify the double entry to achieve this.
The following are often used in practice
Parent sells to associate (or JV):
‰ The unrealised profit is held in inventory of the associate (or JV). The
investment in the associate (or JV) should be reduced by the parent’s share
of the unrealized profit.
‰ The other side of the entry increases cost of sales
Debit Credit
Cost of sales
Investment in associate
Associate (or JV) sells to parent:

‰ The unrealised profit is held in inventory of the parent and this should be
reduced in value by the parent’s share of the unrealized profit.
‰ The other side of the entry reduces the parent’s share of the profit of the
associate (orJV).
Debit Credit
Share of profit of associate
Inventory
In both cases, there should also be a reduction in the post-acquisition profits of

the associate (or JV), and the investor entity’s share of those profits (as reported
in profit or loss). This will reduce the accumulated profits in the statement of
financial position.

Example: Unrealised profit

Entity P acquired 40% of the equity shares of Entity A several years ago. The
cost N
profits N
In the year to 31 December Year 6, Entity P sold goods to Entity A at a sales

price N
N
the year-end.
The necessary adjustments for unrealised profit, and the double entries are as
follows:
Unrealised profit adjustment N
Inventory sold by P to A 200,000
Profit on the sale (u 100% /200%) 100,000
Unrealised profit (u N30,000/N200,000) 15,000
Entity P’s share (40%) 6,000
Double entries: Dr(N) Cr(N)

Investment in associate 110,000
Accumulated profits 110,000
Being: Share of post-acquisition profits (40% of N275,000)
Dr(N) Cr(N)
Cost of sales (hence accumulated profit) 6,000
Being: Elimination of share of unrealized profit (see above)
Investment in associate (see above for adjustments) N

Cost of the investment 205,000
Entity P’s share of post-acquisition profits of Entity A 110,000
Minus: Entity P’s share of unrealised profit in inventory (6,000)
309,000

Financial reporting
Practice question
Entity P acquired 30% of the equity shares of Entity A several years ago
at a N
N
In the year to 31 December Year 6, the reported profits after tax of Entity
A N
In the year to 31 December Year 6, Entity P sold goods to Entity A for
N
N
Entity A at the year-end.
a) Calculate the unrealised profit adjustment and state the

double entry.
Calculate the investment in associate balance that would
be included in Entity P’s statement of financial position as
at 31 December Year 6.
Calculate the amount that would appear as a share of profit
of associate in Entity P’s statement of profit or loss for the
year ending 31 December Year 6.
Define anassociate
Explain equityaccounting
Measure investment in an associate for inclusion in the statement offinancial
position using equity accounting
Measure share of profit of an associate for inclusion in the statement of
Account unrealised profit on transactions between an associate and its parent or a
member of the parent’s group

Financial reporting
The figures that must be included to account for the associate in the financial
statements of Entity P for the year to 31 December Year 5 are as follows:
Statement of financial position:
The investment in the associate is as follows:
N
Investment at cost 128,000
Investor’s share of post-acquisition profits of A (W1) 60,000
Minus: Accumulated impairment in the investment (8,000)
Investment in the associate 180,000
W1 Retained post-acquisition profits of Entity A N

Net assets of the associate at 31 December Year 5 400,000
Net assets of Entity A at date of acquisition of shares (250,000)
Retained post-acquisition profits of Entity A 150,000
Entity P’s share of A 40%
Entity P’s share of A’s profits since the date of acquisition N60,000

The share of the associate’s after-tax profit for the year is shown on a separate line
as: profits ×N50,000): N

Solution 2
a) Unrealised profit adjustment N
Inventory sold by P to A 180,000
Profit on the sale (u20%/120%) 30,000
Unrealised profit (u N60,000/N180,000) 10,000
Entity P’s share (30%) 3,000
Double entry Dr(N) Cr(N)

Cost of sales (hence accumulated profit) 3,000

CHAPT ER
Contents
IAS 10: Events after the reporting period
IAS 24: Related partydisclosures
Chapter review

Financial reporting
INTRODUCTION
Aim
principles.
Detailed syllabus
B
statements
6 Provisions, contingent liabilities and contingent assets and events after
the reporting period (IAS 37 and IAS 10)
Calculate, where necessary, discuss and account for provisions, contingent
liabilities and assets as well as events after the reporting period in accordance
with the provisions of relevant accounting standards (IAS 37 and IAS 10).
IAS 10 and IAS 24 are examinable standards.
Exam context
This chapter explains the main features of IAS 10 and IAS 24.
These standards were examinable in a previous paper. They are covered here again in detail
for your convenience.
By the end of this chapter, you should be able to:
„ Distinguish between adjusting and non-adjusting items
„ Explain and apply the IAS 10 guidance on the recognition of dividends
„ Explain the objective of IAS 24 in setting out rules on disclosure of related party
relationships and transactions
„ Define and identify related parties
„ Prepare related party disclosures based on a scenario

Chapter 22: Sundry standards
1 IAS10: EVENTS AFTER THE REPORTING PERIOD
Purpose of IAS10
Accounting for adjusting events after the reporting period
Disclosures for non-adjusting events after the reporting period
Dividends
The going concern assumption
1.1 Purpose of IAS10

IAS 10 Events after the reporting period has two main objectives:
‰ to specify when a company should adjust its financial statements for events
that occur after the end of the reporting period, but before the financial
statements are authorised for issue, and
‰ to specify the disclosures that should be given about events that have
occurred after the end of the reporting period but before the financial
statements were authorised for issue.
IAS 10 also includes a requirement that the financial statements should disclose
when the statements were authorised for issue, and who gave the authorisation.
IAS 10 sets out the following key definitions.
Definitions
Events after the reporting period: Those events, favourable and unfavourable
that occur between the end of the reporting period and the date the financial
Adjustingevents: Events that provide evidence of conditions that already
existed as at the end of the reporting period.
Non-adjusting events: Events that have occurred due to conditions arising after the
end of the reporting period.

Financial reporting
1.2 Accounting for adjusting events after the reporting period

IAS 10 states that if a company obtains information about an adjusting event after
the reporting period, it should update the financial statements to allow for this new
information.
IAS 10 gives the following examples of adjusting events.
‰ The settlement of a court case after the end of the reporting period,
confirming that the company had a present obligation as at the end of the
reporting period as a consequence of the case.
‰ The receipt of information after the reporting period indicating that an asset
was impaired as at the end of the reporting period.
‰ The discovery of fraud or errors showing that the financial statements are
incorrect.
1.3 Disclosures for non-adjusting events after the reporting period

Non-adjusting events after the reporting period are treated differently. A non-
adjusting event relates to conditions that did not exist at the end of the reporting
period, therefore the financial statements must not be updated to include the
effects of the event. IAS 10 states quite firmly: ‘A company shall not adjust the
amounts recognised in the financial statements to reflect non-adjusting events
after the reporting period’.
However, IAS 10 goes on to say that if a non-adjusting event is material, a failure
by the company to provide a disclosure about it could influence the economic
decisions taken by users of the financial statements. For material non-adjusting
events IAS 10 therefore requires disclosure of:
‰ the nature of the event; and
‰ an estimate of its financial effect or a statement that such an estimate
cannot be made.
IAS 10 gives the following examples of non-adjusting events:
‰ A fall in value of an asset after the end of the reporting period, such as a
large fall in the market value of some investments owned by the company,
between the end of the reporting period and the date the financial
‰ The acquisition or disposal of a major subsidiary.
‰ The formal announcement of a plan to discontinue a major operation.
‰ Announcing or commencing the implementation of a major restructuring.
‰ The destruction of a major plant by a fire after the end of the reporting
period.

1.4 Dividends
IAS 10 also contains specific provisions about proposed dividends and the going
concern presumption on which financial statements are normally based.
If equity dividends are declared after the reporting period, they should not be
recognised, because they did not exist as an obligation at the end of the reporting
period.
Dividends proposed after the reporting period (but before the financial statements
are approved) should be disclosed in a note to the financial statements, in
accordance with IAS 1.
1.5 The going concern assumption

There is one important exception to the normal rule that the financial statements
reflect conditions as at the end of the reporting period.
A deterioration in operating results and financial position after the end of the
reporting period may indicate that the going concern presumption is no longer
appropriate.
There are a large number of circumstances that could lead to going concern
problems. For example:
‰ The financial difficulty of a major customer leading to their inability to pay
their debt to the agreed schedule if at all.
‰ An event leading to the net realisable value of lines of inventory falling to
less than cost.
‰ An event leading to a crucial non-current asset falling out of use. This might
cause difficulties in supplying customers and fulfilling contracts.
‰ A change in market conditions leading to a loss in value of major
investments.
‰ Shortages of important supplies
‰ The emergence of a highly effective competitor.
If it becomes clear that the client cannot be considered to be a going concern, the
financial statements will need to disclose this and the basis for preparing them will
change to the ‘break-up’ basis.
This means that values will have to be adjusted to the amounts expected to be
realised through sale.

2 IAS24: RELATED PARTY DISCLOSURES
Impact on the financial statements

The objective of IAS 24
Definitions

3 CHAPTER REVIEW
Distinguish between adjusting and non-adjusting items
Explain and apply the IAS 10 guidance on the recognition of dividends

CHAPTER
Contents
Statement of cash flows: Introduction
Statement of cash flows: Format
Cash flows from operating activities: The indirect
method
Indirect method: Adjustments for working capital
Cash flows from operating activities: The direct
method
Cash flows from investing activities
Cash flows from financing activities
Chapter review

Financial reporting
INTRODUCTION
Aim
Detailed syllabus
c Prepare and present statement of cash flows for single entities in
accordance with IAS 7 using direct and indirect methods.

(parent, one subsidiary and an associate)
c Prepare and present statement of cash flows of a simple group
(one subsidiary and an associate), in accordance with the
Exam context
This chapter explains how to prepare a statement of cash flow.

„ Prepare extracts from a statement of cashflow
„ Prepare a statement of cashflow

Chapter 23: IAS 7: Statement of cash flows
1 STATEMENT OF CASHFLOWS: INTRODUCTION
Purpose of statement of cash flows

Statement of cashflows
The sections of a statement of cashflows
Cash flows from operating activities
Cash flows from investing activities
Cash flows from financing activities
Gross or net
1.1 Purpose of statement of cashflows

IAS 1 states that a statement of cash flows is a part of a complete set of the
financial statements of an entity. It provides information about:
‰ the cash flows of the entity during the reporting period, and
‰ the changes in cash and cash equivalents during the period.
IAS 7: Statement of cash flows sets out the benefits of cash flow information to
users of financial statements.
‰ A statement of cash flows provides information that helps users to evaluate
changes in the net assets of an entity and in its financial structure (including
its liquidity and solvency).
‰ It provides information that helps users to assess the ability of the entity to
affect the amount and timing of its cash flows in order to adapt to changing
circumstances and unexpected opportunities.
‰ It is useful in assessing the ability of the entity to generate cash and cash
equivalents.
‰ It helps users of accounts to compare the performance of different entities
because unlike profits, comparisons of cash flows are not affected by the
different accounting policies used by different entities.
‰ Historical cash flows are often a fairly reliable indicator of the amount,
timing and certainty of future cashflows.

Financial reporting
1.2 Statement of cashflows

A statement of cash flows provides information about where a business obtained
its cash during the financial period, and how it made use of its cash.
A statement of cash flows groups inflows and outflows of cash under three broad
headings:
‰ cash from operating activities
‰ cash used in (or obtained from) investing activities
‰ cash paid or received in financing activities.
It also shows whether there was an increase or a decrease in the amount of cash
held by the entity between the beginning and the end of the period.
Illustration:
Cash from operating activities X/(X)

Cash used in (or obtained from) investing activities X/(X)
Cash paid or received in financing activities. X/(X)
Net cash inflow (or outflow) during the period X/(X)
Cash and cash equivalents at the beginning of the period X/(X)
Cash and cash equivalents at the end of the period X/(X)
A statement of cash flows reports the change in the amount of cash and cash
equivalents held by the entity during the financial period.
Cash and cash equivalents
Definition: Cash, cash equivalents and cash flows 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 an in significant
risk of changes in value.
Cash flows are inflows and outflows of cash and cash equivalents.
For the purpose of a statement of cash flows, cash and cash equivalents are
treated as being the same thing. This means that cash flows between cash and
cash equivalent balances are not shown in the statement of cash flows. These
components are part of the cash management of an entity rather than part of its
operating, investing and financing activities.
Cash and cash equivalents are held in order to meet short-term cash
commitments, rather than for investment purposes or other purposes.
Examples of cash equivalents are:
‰ a bank deposit where some notice of withdrawal is required
‰ short-term investments with a maturity of three months or less from the
date of acquisition (e.g., government bills).

Chapter 23: IAS 7: Statement of cash flows
Bank borrowings are generally considered to be financing activities. In that case

they would be held outside cash and cash equivalents and movements on the
bank borrowings would be shown under financing activities as a cash inflow if
borrowing increase or as a cash outflow if borrowings fell.
Sometimes, bank overdrafts which are repayable on demand form an integral part
of an entity's cash management. In these circumstances, bank overdrafts are
included as a component of cash and cash equivalents.
Sundry disclosures
An entity must disclose the components of cash and cash equivalents and
present a reconciliation of the amounts in its statement of cash flows with the
equivalent items reported in the statement of financial position.
Any significant cash and cash equivalent balances held by the entity that are not
available for use by the group must be disclosed together with a commentary by
management. This might be the case when a group of companies has a subsidiary
whose dividend payments are subject to a debt covenant or exchange control
regulations which would prevent payment of a dividend to the parent company.
Comment on technique
Theoretically this could be done by analysing every entry in and out of the cash
account(s) over the course of a period. However, the cash account is often the
busiest account in the general ledger with potentially many thousands of entries.
Documents that summarise the transactions are needed.
These documents already exist! They are the other financial statements
(statement of financial position and statement of comprehensive income).
Illustration:
A business might buy 100 new non-current assets over the year. There wouldbe
100 different entries for these in the cash account.
However, it should be easy to estimate the additions figure from comparing the
opening and closing balances for non-current assets and isolating any other
causes of movement.
For example, if we know that property plant and equipment has increased by
N100,000 and that the only other cause of movement was depreciation of
N15,000 then additions must have been N115,000.
A lot of the numbers in cash flow statements are derived from comparing opening
and closing positions of line items in the statement of financial position. Other
causes of movement can then be identified leaving the cash double entry as a
balancing figure.

Financial reporting
1.3 The sections of a statement of cashflows

The content and format of statements of cash flows are specified by IAS 7
Statement of cash flows. IAS 7 does not specify what the exact format of a
statement of cash flows should be, but it provides suggested layouts in an
appendix.
Entities are required by IAS 7 to report cash flows for the period under three
headings:
‰ cash flows from operating activities
‰ cash flows from investing activities
‰ cash flows from financing activities.
All cash flows (except for changes from cash to cash equivalents or from cash
equivalents to cash) can be included in one of these three categories.
Together, the cash flows arising from these three categories of activity explain
the increase or decrease in cash and cash equivalents during the financial
period.
The cash flows for each category might be positive or negative. The total of the
cash flows for all three categories together explains the overall increase or
decrease in cash and cash equivalents during the period.
A single transaction might include more than one type of cash flow. For example,
a cash repayment of a loan might include both interest and capital. In this case
the interest element might be classified as an operating activity and the capital
element as a financing activity.
1.4 Cash flows from operating activities

Operating activities are the normal trading activities of the entity. Cash flows from
operating activities are the cash inflows or cash outflows arising in normal trading
activities.
Operating activities normally provide an operating profit before tax. However,
profit is not the same as cash flow, and the cash flows from operating activities
are different from profit.
A statement of cash flows normally makes a distinction between:
‰ cash generated from operations, which is the cash from sales less the
cash payments for operating costs, and
‰ net cash from operating activities, which is the cash generated from
operations, less interest payments and tax paid on profits.
Cash flows from operating activities are primarily derived from the principal
revenue-producing activities of the entity. Therefore, they generally result from
the transactions and other events that enter into the determination of profit or
loss.

Chapter 23: IAS 7: Statements of cash flows
Examples of cash flows from operating activities are:

‰ cash receipts from the sale of goods and the rendering of services;
‰ cash receipts from royalties, fees, commissions and other revenue;
‰ cash payments to suppliers for goods and services;
‰ cash payments to and on behalf of employees;
‰ cash receipts and cash payments of an insurance entity for premiums and
claims, annuities and other policy benefits;
‰ cash payments or refunds of income taxes unless they can be specifically
identified with financing and investing activities; and
‰ cash receipts and payments from contracts held for dealing or trading
purposes.
Some transactions result in the recognition of a gain or loss profit or loss (e.g.,
sale of an item of plant). However, the cash flows relating to such transactions
are cash flows from investing activities.
Cash payments to manufacture or acquire assets held for rental to others and
subsequently held for sale are cash flows from operating activities. The cash
receipts from rents and subsequent sales of such assets are also cash flows from
operating activities.
The amount of cash flows arising from operating activities is a key indicator of the
extent to which the operations of the entity have generated sufficient cash flows to
function without recourse to external sources of financing. In addition, it forms a
basis for forecasting future operating cashflows.
1.5 Cashflows from investing activities

The second section of a statement of cash flows shows cash flows from investing
activities. Investing activities are defined by IAS 7 as ‘the acquisition and disposal
of long-term assets and other investments not included in cash equivalents’.
Cash flows from investing activities might also include cash received from
investments, such as interest or dividends received.
The separate disclosure of cash flows arising from investing activities is important
because the cash flows represent the extent to which expenditures have been
made for resources intended to generate future income and cash flows.
Examples of cash flows arising from investing activities are:
‰ cash payments to acquire property, plant and equipment, intangibles and
other long-term assets (including those relating to capitalised development
costs and self-constructed tangibleassets);
‰ cash receipts from sales of property, plant and equipment, intangibles and
other long-term assets;
‰ cash payments to acquire equity or debt instruments;
‰ cash receipts from sales of equity or debt instruments of other entities;
‰ cash advances and loans made to other parties (other than advances and
loans made by a financial institution which would be an operating activity);
‰ cash receipts from the repayment of advances and loans made to other
parties (other than advances and loans of a financial institution);

Financial reporting
1.6 Cash flow from financing activities

The third section of the statement of cash flows shows the cash flows from
financing activities. These activities are defined by IAS 7 as ‘activities that
resulting changes in the size and composition of the contributed equity and
borrowings of the entity.’
Examples of cash flows arising from financing activities are:
‰ cash proceeds from issuing shares or other equity instruments;
‰ cash payments to owners to acquire or redeem the entity's shares;
‰ cash proceeds from issuing debentures, loans, notes, bonds, mortgages
and other short-term or long-term borrowings; and
‰ cash repayments of amounts borrowed.
The separate disclosure of cash flows arising from financing activities is important
because it is useful in predicting claims on future cash flows by providers of capital
to the entity.
1.7 Gross or net

Generally, major classes of cash flows arising from investing and financing
activities are reported gross. That is to say that cash receipts and cash payments
are shown separately even if from and to the same party.
However, cash flows arising from the following activities may be reported on a net
basis:
‰ cash receipts and payments on behalf of customers when the cash flows
reflect the activities of the customer rather than those of the entity (for
example if rent is collected on behalf of and paid on to owners of
properties); and
‰ cash receipts and payments for items in which the turnover is quick, the
amounts are large, and the maturities are short (e.g., payments made by
credit card companies on behalf of their customers and receipts from those
customers.
It is unlikely that you will see this in a question.

2 STATEMENT OF CASH FLOWS: FORMAT
Format
The indirect method
The direct method
2.1 Format
IAS 7 does not include a format that must be followed. However, it gives
illustrative examples of formats that meet the requirements in the standard.
This section provides examples of these.
Illustration: Statement of cash flows
N N
Net cash flow from operating activities 75,300
Cash flows from investingactivities:

Acquisition of shares (debentures, etc.) (5,000)
Purchase of property, plant and machinery (35,000)
Proceeds from sale of non-current assets 6,000
Interest received/dividends received 1,500
Net cash used in investing activities (32,500)
Cash flows from financing activities:

Proceeds from issue of shares 30,000
Proceeds from new loan 10,000
Repayment of loan (17,000)
Dividends paid to shareholders (25,000)
Net cash used in financing activities (2,000)
Net increase/decrease in cash/cash equivalents 40,800
Cash/cash equivalents at the beginning of the year 5,000
Cash/cash equivalents at the end of the year 45,800
Operating cash flows

IAS 7 permits two methods of presenting the cash flows from operating activities:
‰ the direct method, and
‰ the indirect method.
For clarity, what this means is that there are two approaches to arriving at the
figure of ࠸75,300 in the above example.
IAS 7 allows entities to use either method of presentation. It encourages entities
to use the direct method. However, the indirect method is used more in practice.

Financial reporting
The two methods differ only in the way that they present the cash flows for cash
generated from operations. In all other respects, the figures in the statement of
cash flows using the direct method are identical to the figures in a statement
using the indirect method – cash flows from investing activities and financing
activities are presented in exactly the same way.
2.2 The indirect method

The indirect method identifies the cash flows from operating activities by
adjusting the profit before tax figure. It arrives at the cash from operating
activities figure indirectly by reconciling a profit figure to a cash figure.
The adjustments remove the impact of accruals and non-cash items and also
relocate some figures to other positions in the statement of cash flows.
The following illustration shows how the net cash flow from operating activities
figure seen in the previous example was arrived at using the indirect method.
Illustration:
Statement of cash flows: indirect method N N

Profit before taxation 80,000
Adjustments for:
Depreciation and amortisation charges 20,000
Interest charges in the statement of comprehensive 2,300
income
Gains on disposal of non-current assets (6,000)
Losses on disposal of non-current assets 4,500
100,800
Increase in trade and other receivables (7,000)
Decrease in inventories 2,000
Increase in trade payables 3,000
Cash generated from operations 98,800
Taxation paid (tax on profits) (21,000)
Interest charges paid (2,500)

2.3 The direct method

The direct method calculates the cash flow from operating activities by
calculating cash received from customers, cash paid to suppliers and so on.
The following illustration shows how the net cash flow from operating activities
figure seen in the previous example was arrived at using the direct method.
Illustration:
Statement of cash flows: direct method N

Cash receipts from customers 348,800
Cash payments to suppliers (70,000)
Cash payments to employees (150,000)
Cash paid for other operating expenses (30,000)
The figures in the two statements are identical from ‘Cash generated from
operations’ down to the end. The only differences are in the presentation of the
cash flows that produced the ‘Cash generated from operations’.

Financial reporting
3 CASHFLOWS FROM OPERATING ACTIVITIES: THE INDIRECT METHOD
Profit before taxation

Non-cash items
Accruals based figures -Interest
Accruals based figures -Taxation
Accruals based figures -Dividends
Presentation of interest, taxation, and dividends cashflows
3.1 Profit before taxation

The starting point for the statement of cash flows for a company is the operating
profit after deducting interest but before taxation.
This profit figure is adjusted to calculate the amount of cash received by the
business or the amount of cash paid out as a consequence of its trading
operations.
The adjustments are to remove the effect of:
‰ Non-cash items, for example:
x Depreciation and amortisation (depreciation of intangible non-current
assets);
x Profit or loss on disposal of non-current assets; and
‰ Accruals based figures, for example:
x Interest expense or income;
x Movement on working capital items (receivables, payables and
inventory).
3.2 Non-cash items
Depreciation and amortisation

Depreciation charges and amortisation charges are not cash flows. They are
expenses in the income statement, but do not represent payments of cash.
In order to obtain a figure for cash flow from the figure for profit, charges for
depreciation and amortisation must therefore be added back to the profit figure.
Gains or losses on disposal of non-current assets

Gains or losses on the disposal of non-current assets are not cash flows. The
gain or loss is calculated as the difference between:
‰ the net cash received from the disposal, and
‰ the carrying value (net book value) of the asset at the date of disposal.

The effect of the gain or loss on disposal (a non-cash item) from the operating
profit is removed by:
‰ deducting gain on disposal; and
‰ adding back losses ondisposal.
The relevant cash flow is the net cash received from the sale. This is included in
cash flows from investing activities as the net cash flows received from the
disposal of non-current assets.
Example:
quipment
Cost 60,000
Carrying value at date of disposal 28,000
Cash proceeds from sale 40,000
statement
adjustment to the operating profit.
inflow
‘Cash flows from investing activities’.
Practice question
A company made a loss on the disposal of a company motor vehicle of
What are the items that should be included for the disposal of the vehicle in
the statement of cashflows for the year:
In the adjustments to get from operating profit to cashflow from
operations?
Under the heading: ‘Cashflows from investing activities’?

Financial reporting
3.3 Accruals based figures -Interest

The accruals concept is applied in accounting.
Interest charge in the income statement is an accrual based figure. It is added
back to profit and the actual cash interest paid is deducted further down the cash
flow statements.
The final items in the operating cash flows part of a statement of cash flows are
the amount of interest paid and the amount of tax paid (see later).
This figure must be calculated as follows:
N
Interest liability at the beginning of the year
Interest charge for the year (income statement figure) X
Total amount of interest payable in the year X
Interest liability at the end of the year (X)
Interest paid in the year (cash) X
Take a few minutes to make sure that you are happy about this. The same
approach is used to calculate other figures.
The interest liability at the start of the year and the interest charge during the year
is the most the business would pay. If the business had paid nothing it would owe
this figure. The difference between this amount and the liability at the end of the
year must be the amount that the business has paid.
Example: Interest paid

A company had liabilities in its statement of financial position at the beginning
and at the end of 20X9, as follows:
Beginning of 20X9 4,000

End of 20X9 3,000
in
The interest payment for inclusion in the statement of cashflows can be

calculated as follows:
Liability at the start of the year 4,000

Charge for the year 22,000
Total amount payable in the year 26,000
Liability at the end of the year (3,000)
Cash paid 23,000

Note that this approach would work to find the cash paid in respect of any liability
in respect of which expense was recognised in the statement of profit or loss.
It would not matter if you did not know anything about the type of liability as long
as you are told that there is a movement and you are given the amount
recognised in the statement of profit or loss. For example, instead of the above
example being about interest it could be about warranty provision, gratuity,
retirement benefit, health insurance, bonus pool, and so on.
3.4 Accruals based figures -Taxation

The tax paid is the last figure in the operating cash flow calculation.
There is no adjustment to profit in respect of tax. This is because the profit figure
that we start with is profit before tax; therefore, tax is not included in it to be
adjusted!
However, there is a tax payment and this must be recognised as a cash flow. It is
calculated in the same way as shown above.
Example: Taxation paid

A company had liabilities in its statement of financial position at the beginning and at
the end of 20X9, as follows:
N
End of 20X9 61,000
profits N
The tax payment (cashflows)for inclusion in the statement of cashflows can

be calculated as follows:
N
Taxation liability at the start of the year 53,000
Charge for the year 77,000
Total amount payable 130,000
Taxation liability at the end of the year (61,000)
Cash paid 69,000
Deferred taxation
A question might include deferred taxation. You have not covered this yet but it
can still be dealt with here as its impact on a statement of cash flows at this level
is quite straightforward.
A deferred tax balance might be an asset or a liability. Deferred tax liability is
more common (in practice and in questions) so this discussion will be about
liabilities.
A deferred tax liability is an amount that a company expects to pay in the future.
Therefore, it has had no cash effect to date.

Financial reporting
Any movement on the deferred tax liability will be due to a double entry to tax expense
in the profit or loss section of the statement of comprehensive income. (There are
double entries to other comprehensive income and directly to equity but these are
outside the scope of your syllabus).
There are two possible courses of action in dealing with deferred tax. Either:
‰ ignore it entirely and work with numbers that exclude the deferred tax (in
effect this was what happened in the example above where there was no
information about deferred tax); or
‰ include it in every tax balance in the working. The
second approach is usuallyused.
Example: Deferred tax

A company had liabilities in its statement of financial position at the beginning and at
the end of 20X9, as follows:
Taxation Deferred
(N) taxation(N)
Beginning of 20X9 53,000 20,000
End of 20X9 61,000 30,000
The tax expense for the year in the statement of profit or loss was N
N
N The tax payment (cashflows) for inclusion in the statement of cashflows can
N
Liability at the start of the year (53,000 + 20,000) 73,000

Charge for the year (77,000 + 10,000) 87,000
Total amount payable in the year 160,000
Liability at the end of the year (61,000 + 30,000) (91,000)
Cash paid 69,000

3.5 Accruals based figures – Dividends

A question might require the calculation of cash paid out as dividends in the year.
This is calculated in the usual way remembering that the dividend charge is a
debit in the statement of changes in equity.
N
Dividend liability at the beginning of the year
Dividend charge for the year
Total amount of dividend payable in the year X
Dividend liability at the end of the year X
Dividend paid in the year (cash) (X)
X

Financial reporting
Example: Dividend paid

A company had liabilities in its statement of financial position at the beginning
and at the end of 20X9, as follows:
N
End of 20X9 71,000
capital N
The directors recommended a dividend of 20% (20X8: 18%) on 25th
December 20X9.
The company AGM is held in March each year.
The dividend payment (cashflows) for inclusion in the statement of

cash flows can be calculated as follows:
N
Dividend liability at the start of the year 65,000
Dividend in the year (18% of 1,000,000) 180,000
Total amount payable 245,000
Dividend liability at the end of the year (71,000)
Cash paid 171,000
3.6 Presentation of interest, taxation and dividends cashflows

IAS 7 allows some variations in the way that cash flows for interest and dividends
are presented in a statement of cash flows, although the following should be
shown separately:
‰ Interest received
‰ dividends received
‰ interest paid
‰ dividends paid.
Interest payments
IAS 7 states that there is no consensus about how to treat interest payments by
an entity, other than a financial institution such as a bank. Interest payments may
be classified as either:
‰ an operating cash flow, because they are deducted when calculating
operating profit before taxation, or
‰ a financing cash flow, because they are costs of obtaining finance.
In examples of statements of cash flows in the appendix to IAS 7, interest paid is
shown as a separate line item within cash flows from operating activities. This
approach is therefore used here.

Interest and dividends received

Interest received and dividends received may be classified as either:
‰ an operating cash flow, because they are added when calculating operating
profit before taxation, or
‰ an investing cash flow, because they represent returns oninvestment.
In examples of statements of cash flows in the appendix to IAS 7, interest
received and dividend received are shown as separate items within cash flows
from investing activities. This approach is therefore used here.
Dividends paid
IAS 7 allows dividend payments to be treated as either:
‰ a financing cash flow because they are a cost of obtaining financial
resources, or
‰ a component of the cash flows from operating activities, in order to assist
users to determine the ability of the entity to pay dividends out of its
operating cashflows.
In examples of statements of cash flows in the appendix to IAS 7, dividends paid
are shown as a line item within cash flows from financing activities. This approach
is therefore used here.
Taxes on profits
Cash flows arising from taxation on income should normally be classified as a
cash flow from operating activities (unless the tax payments or refunds can be
specifically associated with an investing or financing activity).
The examples of statements of cash flows in this chapter therefore show both
interest paid and tax paid as cash flow items, to get from the figure for cash
generated from operations to the figure for ‘net cash from operating activities’.

Financial reporting
4 INDIRECTMETHOD: ADJUSTMENTS FOR WORKING CAPITAL
Working capital adjustments: Introduction

Working capital
Changes in trade and other receivables
Possible complication: Allowances for doubtful debts
Changes in inventory
Changes in trade payables
Lack of detail
4.1 Working capital adjustments: Introduction
Definition
Working capital is current assets less current liabilities.
The previous section showed that taxation and interest cash flows can be
calculated by using a figure from the statement of comprehensive income and
adjusting it by the movement on the equivalent balances in the statement of
financial position.
This section shows how this approach is extended to identify the cash generated
from operations by making adjustments for the movements between the start and
end of the year for elements of working capital, namely:
‰ trade receivables and prepayments;
‰ inventories; and
‰ trade payables and accruals.
Assuming that the calculation of the cash flow from operating activities starts with
a profit (rather than a loss) the adjustments are as follows:
Increase in balancefromstart Decrease in balance from

Balance
to the end of the year start to the end of the year
Receivables Subtract from profit before tax Add back to profit before tax Inventory
Subtract from profit before tax Add back to profit before tax
Payables Add back to profit before tax Subtract from profit before tax
These are known as the working capital adjustments and are explained in more
detail in the rest of this section.

4.2 Working capital

Working capital is made up of the following balances:
Inventory
Trade and other receivables
Cash
Tradepayables
Workingcapital
Trade and other receivables include any prepayments.

Trade payables include accrued expenses, provided the accrued expenses do
not relate to other items dealt with separately in the statement of cash flows, in
particular:
‰ accrued interest charges; and
‰ taxation payable.
Interest charges and payments for interest are presented separately in the
statement of cash flows, and so accrued interest charges should be excluded
from the calculation of changes in trade payables and accruals.
Similarly, taxation payable is dealt with separately; therefore, taxation payable is
excluded from the calculation of working capital changes.
Accrued interest and accrued tax payable must therefore be deducted from the
total amount for accruals, and the net accruals (after making these deductions)
should be included with trade payables.
Changes in working capital and the effect on cash flow

When working capital increases, the cash flows from operations are less than the
operating profit, by the amount of the increase.
Similarly, when working capital is reduced, the cash flows from operations are
more than the operating profit, by the amount of the reduction.
This important point will be explained with several simple examples.

Financial reporting
4.3 Changes intrade and other receivables

Sales revenue in a period differs from the amount of cash received from sales by
the amount of the increase or decrease in receivables during the period.
When trade and other receivables go up during the year, cash flows from
operations are less than operating profit by the amount of the increase.
When trade and other receivables go down during the year, cash flows from
operations are more than operating profit by the amount of the reduction.
In a statement of cash flows presented using the indirect method, the adjustment
for receivables is therefore:
‰ subtract the increase in receivables during the period (the amount by which
closing receivables exceed opening receivables); or
‰ add the reduction in receivables during the period (the amount by which
opening receivables exceed closingreceivables).
Prepayments in the opening and closing statement of financial position should be
included in the total amount of receivables.
Example: trade and other receivables

N
N
N in N al in
cash.
for
N N N30,000).
The cash flow from operations is calculated as follows:
N
Adjustments for increase in receivables (9,000–6,000) (3,000)
17,000
Proof
Cashflow from operations can be calculated as follows:
N
Receivables at the beginning of the year 6,000
Sales in the year 50,000
56,000
Receivables at end of the year (9,000)
Cash received 47,000
Cash paid (purchases) (30,000)
Cash flow from operations 17,000

4.4 Possible complication: Allowances for doubtful debts

A question might provide information on the allowance for doubtful debts at the
start and end of the year.
There are two ways of dealing with this:
‰ Adjust the profit for the movement on the allowance as a non-cash item and
adjust the profit figure for the movement in receivables using the gross
amounts (i.e. the balances before any deduction of the allowance for doubtful
debts); or
‰ Make no adjustments for the movement on receivables as a non-cash item
adjust the profit figure for the movement in receivables using the net
amounts (i.e., the balances after the deduction of the allowance for doubtful
debts).
Example: Allowance for doubtful debts

The following information is available:
20X8 20X9
(N m) (Nm)
Receivables 5,000 7,100
Allowance for doubtful debts (500) (600)
Net-amount 4,500 6,500
N N
Profit before taxation
Adjustments for non-cash items:
Increase in allowance for doubtful debts
10,100
Increase in receivables:
Gross amounts:(7,100–5,000) (2,100)
Neta mounts:(6,500–4,500) (2,000)
8,000 8,000

Financial reporting
4.5 Changes in inventory

Purchases in a period differ from the cost of sales by the amount of the increase
or decrease in inventories during the period.
If all purchases were paid for in cash, this means that cash payments and the
cost of sales (and profit) would differ by the amount of the increase or decrease
in inventories.
When the value of inventory goes up between the beginning and end of the year,
cash flows from operations are less than operating profit by the amount of the
increase.
When the value of inventory goes down between the beginning and end of the
year, cash flows from operations are more than operating profit by the amount of
the reduction.
for inventories is therefore:
‰ subtract the increase in inventories during the period (the amount by which
closing inventory exceeds opening inventory); or
‰ add the reduction in inventories during the period (the amount by which
opening inventory exceeds closing inventory).
Example: inventory
N
N
N
beginning or end of the year.
N in
for N
N
Sales 50,000
Purchases in the year (all paid in cash) 28,000
33,000
Cost of sales (30,000)

N
Profit before tax
Adjustments for:
decrease in inventory (5,000 – 3,000) 2,000
22,000
Proof: The cash flow from operations is calculated as follows:

N
Cash from sales in the year
50,000
Purchases paid in cash (28,000)
4.6 Changes in tradepayables

Payments for purchases in a period differ from purchases by the amount of
increase or decrease in trade payables during the period.
When trade payables go up between the beginning and end of the year, cash
flows from operations are more than operating profit by the amount of the
increase.
When trade payables go down between the beginning and end of the year, cash
flows from operations are less than operating profit by the amount of the
reduction.
for trade payables is therefore:
‰ add the increase in trade payables during the period (the amount by which
closing trade payables exceed opening tradepayables); or
‰ subtract the reduction in trade payables during the period (the amount by
which opening trade payables exceed closing trade payables).
Accruals in the opening and closing statement of financial position should be
included in the total amount of trade payables.
However, deduct interest payable and tax payable from opening and closing
payables, if the total for payables includes these items.

Financial reporting
Example: trade payables

A company had no inventory and no receivables at the beginning and end of
the for in N
N
N
N
for N N N
N

Adjustments for:
Increase in payables (6,500 – 4,000) 2,500
22,500
Proof: The cashflow from operations is calculated as

follows:
N
Trade payables at the beginning of the year
4,000
Purchases in the year 30,000
34,000
Trade payables at the end of the year (6,500)
Cash paid to suppliers 27,500
Cash from sales (50,000)
flow N profit,
N

Example:
N in
just N
N
interest charges. Values of working capital items at the beginning and end of
the year were:
Receivables Inventory Trade payables

Beginning of the year N N
9,000 3,000 4,000
End of the year N N N
N
6,000 5,000 6,500
Required
Calculate the amount of cash generated from operations, as it would be shown
in a statemen tof cashflows using the indirect method.
N N

Adjustments for:
26,000
Decrease in trade and other receivables 3,000
Increase in inventories (2,000)

Practice question
Values of working capital items at the beginning and end of the year
were:
Receivables Inventory Trade payables
Beginning of the year N32,000 N49,000 N17,000
End of the year N27,000 N53,000 N11,000
Calculate the net cash from operating activities, as it would be shown

in a statement of cash flows (indirect method).
4.7 Lack of detail

A question might not provide all the detail needed to split out working capital into
all of its component parts. If this is the case the adjustment must be made using
whatever totals are available in the question.
Example:
in just
interest charges. Values of working capital items at the beginning and end of the
year were:
Current assets Trade payables

Beginning of the year N12,000 N4,000
End of the year N11,000 N6,500
Required
Calculate the amount of cash generated from operations, as it would be shown
in a statement of cashflows using the indirect method.

N N
Adjustments for:
26,000
Decrease in current assets 1,000

Financial reporting
5 CASHFLOWS FROM OPERATING ACTIVITIES: THE DIRECT METHOD
Cash fromsales
Cash paid for materials
Cash paid for wages and salaries
Cash paid for other expenses
5.1 Cash from sales

The format for the direct method of presenting a statement of cash flows is as
follows:
Illustration:
Statement of cash flows: direct method N

Cash receipts from customers 348,800
Cash payments to suppliers (70,000)
Cash payments to employees (150,000)
The task is therefore to establish the amounts for cash receipts and cash
payments. In an examination, you might be expected to calculate any of these
cash flows from figures in the opening and closing statements of financial
position, and the statement of comprehensive income.
The cash receipts from sales during a financial period can be calculated as
follows:

Trade receivables at the beginning of the X

year Sales in the year X
Trade receivables at the end of the (X)

year Cash from sales during the
X
AT account could also be used to calculate the cash
receipt
Balanceb/f Receivables
5.2 Cash paid for materials

To calculate the amount of cash paid to suppliers, you might need to calculate
first the amount of material purchases during the period.
Closing inventory at the end of the year X

Cost of sales X
X
Opening inventory at the beginning of the year (X)
Purchases in the year X
Having calculated purchases from the cost of sales, the amount of cash
payments for purchases may be calculated from purchases and opening and
closing trade payables.

Financial reporting
Trade payables at the beginning of the year X

Purchases in the year (as above) X
Trade payables at the end of the year (X)

Cash paid for materials X

paid
Payables
Balance b/f X
Cash (balancing figure) X Purchases X
Balance c/f X
X X
Note that if the business had paid for goods in advance at the start or end of the
year they would have an opening or closing receivable but this situation would be
quite unusual.
5.3 Cash paid for wages and salaries

Cash payments for wages and salaries can be calculated in a similar way.
Accrued wages and salaries at the beginning of the year X

Wages and salaries expenses in the year X
X
Accrued wages and salaries at the end of the year (X)
Cash paid for wages and salaries X

paid
Payables
Balance b/f X
Cash (balancing figure) X Wages and salaries X
Balance c/f X
X X
If wages and salaries had been paid in advance the business would have a
receivable and the workings would change to the following.

N
Wages and salaries paid in advance at the beginning of the
year (X)
Wages and salaries expenses in the year X
X
Wages and salaries paid in advance at the end of the year X
Cash paid for wages and salaries X

paid
Payables
Balanceb/f X
Cash(balancingfigure) X Purchases
5.4 Cash paid for other expenses

Other expenses in the statement of comprehensive income usually include
depreciation charges, which are not cash flows. Depreciation charges should
therefore be excluded from other expenses when calculating cash payments.
Cash payments for other expenses can be calculated as follows.
Payables for other expenses at the beginning of the year

Other expenses in the year, excluding depreciation and
amortisation X
X
Payables for other expenses at the end of the year
Cash paid for other expenses
Payables for other expenses should exclude accrued wages and salaries,
accrued interest charges and taxation payable.

Financial reporting
Example:
The following information has been extracted from the financial
Hopper statements of
Company for the year ended 31 December 20X9.
N
Sales 1,280,000
Cost of sales (400,000)
Wages and salaries (290,000)
Other expenses (including depreciation N25,000) (350,000)
240,000
Interest charges (50,000)
Tax on profit (40,000)
Extracts from the statement of financial position:

At 1 January At 31 December
20X9 20X9
N N
Trade receivables 233,000 219,000
Inventory 118,000 124,000
Trade payables 102,000 125,000
Accrued wages and salaries 8,000 5,000
Accrued interest charges 30,000 45,000
Tax payable 52,000 43,000
Required
Present the cash flows from operating activities as they would be presented in a
statement of cash flows using:
the direct method; and
the indirect method.

Answer: Direct method

Statement of cashflows: direct method N
Cashflows from operating activities
Cash receipts from customers (W1) 1,294,000
Cash payments to suppliers (W3) (383,000)
Cash payments to employees (W4) (293,000)
Taxation paid (tax on profits) (W5) (49,000)
Interest charges paid (W5) (35,000)
Workings
(W1) Cash from sales N
Trade receivables at 1 January 20X9 233,000
Sales in the year 1,280,000
1,513,000
Trade receivables at 31 December 20X9 (219,000)
Cash from sales during the year 1,294,000
(W2) Purchases N
Closing inventory at 31 December 20X9 124,000
Cost of sales 400,000
524,000
Opening inventory at 1 January 20X9 (118,000)
Purchases in the year 406,000
(W3) Cash paid for materials supplies N

Trade payables at 1 January 20X9 102,000
Purchases in the year (W2) 406,000
508,000
Trade payables at 31 December 20X9 (125,000)
Cash paid for materials 383,000

Financial reporting
(W4) Cash paid for wages and salaries N

Accrued wages and salaries at 1 January 20X9 8,000
Wages and salaries expenses in the year 290,000
298,000
Accrued wages and salaries at 31 December 20X9 (5,000)
Cash paid for wages and salaries 293,000
(W5) Interest and tax payments Tax Interest

N N
Liability at the beginning of the year 52,000 30,000
Taxation charge/interest charge for the year 40,000 50,000
92,000 80,000
Liability at the end of the year (43,000) (45,000)
Tax paid/interest paid during the year 49,000 35,000
Statement of cash flows: indirect method N

Adjustments for:
Interest charges in the statement of comprehensive income 50,000
265,000
Decrease in receivables (233,000 – 219,000) 14,000
Increase in inventories (124,000 – 118,000) (6,000)
(125,000 + 5,000) – (102,000 + 8,000)
Taxation paid (49,000)

6 CASHFLOWS FROM INVESTING ACTIVITIES
Cash paid for the purchase of property, plant and equipment

Cash from disposals of property, plant and equipment
Cash paid for the purchase of investments and cash received from the sale of
investments
Non-cash purchases
6.1 Cashpaid for the purchase of property plant and equipment

This is the second part of a statement of cash flows, after cash flows from
operating activities.
The most important items in this part of the statement are cash paid to purchase
non-current assets and cash received from the sale or disposal of non-current
assets, but it also includes interest received and dividends received on
investments.
It is useful to remember the following relationship:
Carrying amount at the start of the year

Depreciation (X)
Disposals (X)
Additions X
Revaluation X/(X)
Carrying amount at the end of the year

Financial reporting
When there are no disposals or revaluations during the year

When there are no disposals or revaluations of non-current assets during the
year, purchases of non-current assets (normally assumed to be the amount of
cash paid for these purchases) may be calculated as follows:
Illustration:
Using cost:
Non-current assets at the beginning of the year at cost
Additions to non-current assets (balancing figure)
Non-current assets at the end of the year at cost
Alternatively carrying amount (NBV) can be used

Non-current assets at the beginning of the year at NBV
Depreciation

Non-current assets at the end of the year at NBV
Example: Cash paid for property, plant and equipment

The plant and equipment of PM Company at the beginning and the end of its
financial year were as follows:
Accumulated Net book
At cost depreciation value
N N N
Beginning of the year 180,000 (30,000) 150,000
End of the year 240,000 (50,000) 190,000
There were no disposals of plant and equipment during the year.

The cash paid for plantand equipment in the year (additions) may be calculated
in either of the following ways.
Cost or NBV
Balance at the start of the year 180,000 150,000
Less: Depreciation charge for the
year (50,000 – 30,000) (20,000)
Additions (balancing figure) 130,000
60,000 60,000

Note that in the above example it is assumed that the purchases have been
made for cash. This might not be the case. If the purchases are on credit the
figure must be adjusted for any amounts outstanding at the year end.

PM company has purchased various items of property, plant and equipment on
The statements of financial position of PM company at the beginning and end of

20X9 include the following information:
Payables: 20X8(Nm) 20X9(Nm)
Suppliers of non-current assets 4,000 12,000
The cash paid to buy property, plantand equipment in the year can
be calculated asfollows:
Additions 60,000
Less: increase in payables that relate to these items (8,000)
Cash paid in the year 52,000
this
If the payables had decreased the movement would be added to the additions
figure to find the cash outflow.

PM company has purchased various items of property, plant and equipment on
The statements of financial position of PM company at the beginning and end of

Payables: 20X8(Nm) 20X9(Nm)
Suppliers of non-current assets 14,000 4,000
The cash paid to buy property, plantand equipment in the year can
Additions 60,000
Plus: decrease in payables that relate to these items 10,000
Cash paid in the year 70,000
this

Financial reporting
When there are disposals during the year

When there are disposals of non-current assets during the year, the purchases of
non-current assets may be calculated as follows:
Assets at cost at the beginning of the year X

Disposals during the year (cost)
X
Additions to non-current assets (balancing figure) X
Assets at cost at the end of the year

Non-current assets at the beginning of the year at NBV X
Depreciation
Disposals during the year (NBV)

Example: Cash paid for property, plant and equipment with disposals
The motor vehicles of PM Company at the beginning and the end of its financial
year were as follows:
Accumulated Carrying
At cost depreciation amount
N N N
Beginning of the year 150,000 (105,000) 45,000
End of the year 180,000 (88,000) 92,000
for
this
Additions may be calculated as follows:

Cost NBV
Disposals during the year:
At cost (60,000)
At carrying amount: (60,000 – 45,000) (15,000)
Depreciation (88,000 – (105,000 – 45,000) (28,000)
90,000 2,000
Additions (balancing figure) 90,000 90,000
Balance at the end of the year 180,000 92,000

When there are revaluations during the year

When there are revaluations of non-current assets during the year, the purchases
of non-current assets should be calculated as follows.
At cost or valuation, at the beginning of the year

Disposals during the year (cost)
Upward/(downward) revaluation during the year
X
At cost or valuation, at the end of the year

Non-current assets at the beginning of the year at NBV X
Depreciation
Disposals during the year (NBV)
Upward/(downward) revaluation during the year
X
Example:
The statements of financial position of Grand Company at the beginning and end
of 20X9 include the following information:
Property, plant and equipment 20X8 20X9
N N
At cost/re-valued amount 1,400,000 1,900,000
Accumulated depreciation 350,000 375,000
Carrying value 1,050,000 1,525,000
item of equipment was disposed of during the year at a profit of
in

Financial reporting
Example (continued)
Carrying
Cost amount
N N
Balance at the start of the year 1,400,000 1,050,000
At cost (260,000)
Depreciation (265,000)
Revaluation 200,000 200,000
1,340,000 965,000
Balance at the end of the year 1,900,000 1,525,000
The revaluation recognised in the year can be found by comparing the opening
and closing balances on the revaluation surplus account. There might also be
revaluation double entry recognised as a gain or loss in other comprehensive
income.
You need the total for revaluation recognised in the year so you may have to add
or net both of these amounts.
Revaluation accounting is explained in detail in chapter 7.
When there are other additions during the year

The above example showed the need to take revaluation into account when
reconciling the opening and closing balances on non-current assets so as to find
the additions figure as a balancing amount.
This applies to other additions too:
‰ Transfers from capital work inprogress
x These are assets constructed by a company for its own use.
x During the course of construction costs are accumulated in a capital
work in progress account and these are transferred into the relevant
category of non-current asset on completion.
x The cash consequence of capital work in progress is estimated as a
separate exercise.
x Transfers into the relevant category of non-current asset on
completion show as an addition and so must be taken into account
when trying to estimate the cash additions.

Example:
The statements of financial position of Grand Company at the beginning and end
of 20X9 include the following information:
Property, plant and equipment 20X8 20X9

N N
At cost/re-valued amount 1,400,000 1,900,000
Accumulated depreciation 350,000 375,000
Carrying value 1,050,000 1,525,000
Capital work in progress 600,000 620,000

During the year:
in
capital in

Financial reporting
Example (continued)
Carrying
Cost amount
N N
Balance at the start of the year 1,400,000 1,050,000
At cost (260,000)
Depreciation (265,000)
Revaluation 200,000 200,000
Additions – Transfer from capital WIP (W) 180,000 180,000
1,520,000 1,145,000
Balance at the end of the year 1,900,000 1,525,000
Capital work in progress

Balance at the start of the year 600,000
New WIP capitalised 200,000
800,000
Transfer to property, plantand equipment
(balancing figure) (180,000)
Balance at the end of the year 620,000

6.2 Cash from disposals of property plantand equipment

A statement of cash flows should include the net cash received from any
disposals of non-current assets during the period.
This might have to be calculated from the gain or loss on disposal and the
carrying amount of the asset at the time of its disposal.
At cost (or re-valued amount at the time of disposal)

Accumulated depreciation, at the time of disposal
Net book value/carrying amount at the time of disposal
Gain or (loss) on disposal X
Net disposal value (= assumed cash flow) X
If there is a gain on disposal, the net cash from the disposal is more than the net
book value.
If there is a loss on disposal the net cash from the disposal is less than the net
book value.
Example:
me
What was the amount of cash obtained from the disposal of the asset?
Disposal of equipment N
At cost 70,000
Accumulated depreciation, at the time of disposal (56,000)
Net book value/carrying amount at the time of disposal 14,000
Net disposal value (assumed cash flow) 20,000
This cash flow would be included in the cashflows from investing activities.
Note that in the above example it is assumed that the cash received for the
disposal has been received. This might not be the case. If the disposal was on
credit the figure must be adjusted for any amounts outstanding at the year end.

Financial reporting
Practice question
financial
plant
not
this
Another non-current asset was re-valued upwards during the year from
Calculate the following amounts, for inclusion in the cash flows from
investing activities section of the company’s statement of cash flows for
20X9:
Purchases of property, plant and equipment
Proceeds from the sale of non-current assets

6.3 Cash paid for the purchase of investments and cash received from the
sale of investments
A statement of cash flows should include the net cash paid to buy investments in
the period and the cash received from the sale of investment in the period.
It is useful to remember the following relationship:
Carrying amount at the start of the year (X)

Disposals
Additions X/(X)
Revaluation
Carrying amount at the end of the year
The issues to be considered in calculating cash paid for investments or cash

received on the sale of investments are very similar to those for the purchase and
sale of property, plant and equipment except for the absence of depreciation.
Example: Cash paid for investments

The statements of financial position of Grand Company at the beginning and end of
Non-currentasset investments 1,000 1,500
Additional information:
The investments were revalued upwards during the year. Are valution
for in
The cash paid to buy investments in the period can bec alculated as a
balancing figure as follows:
Investments at the start of the year (given) 1,000

Disposal (carrying amount of (200)
investments sold = N250m – N50m)
Revalution gains (given 150
950
Additions (as balancing figure): 550
Investments at the end of the year (given) 1,500

Financial reporting
6.4 Non-cash purchases

IAS 7 states that investing and financing transactions that do not require the use
of cash must be excluded from the statement of cash flows, but that details of
these transactions should be disclosed somewhere in the financial statements,
possibly as a note to the financial statements.

7 CASH FLOWS FROM FINANCING ACTIVITIES
Examples of cash flows from financing activities

Cash from new share issues
Cash from new loans/cash used to repay loans
Dividend payments to equity shareholders
7.1 Examples of cashflows from financing activities

Examples of cash flows from financing activities are listed below:
Cash payments Cash receipts

Cash payments to redeem/buy back Cash proceeds from issuing shares
shares
Cash payments to repay a loan or Cash proceeds from a loan or issue of
redeem bonds bonds
As explained earlier, payments of dividends are also usually included within cash
flows from financing activities, in this part of the statement of cash flows. (Some
entities may also include interest payments in this section, instead of including
them in the section for cash flows from operating activities.)
7.2 Cash from new share issues

The cash raised from new share issues can be established by comparing the
equity share capital and the share premium in the statements of financial position
at the beginning and the end of the year.
Share capital + Share premium at the end of the year

Share capital + Share premium at the beginning of the year
Cash obtained from issuing new shares in the year

Financial reporting
Example:
The statements of financial position of Company Pat 1 January and 31
December included the following items:
1 January 20X9 31 December 20X9
N N
Equity shares 600,000 750,000
Share premium 800,000 1,100,000
The cash obtained from issuing shares during the year is calculated as
follows.
Share capital + Share premium at the end of 20X9 1,850,000

Share capital + Share premium at the beginning of 20X9 (1,400,000)
Cash obtained from issuing new shares in 20X9 450,000
The above example assumes that the only cause of movement on the share
capital and share premium account was an issue of shares for cash. A question
may provide information about a non-cash movement (e.g., a bonus issue or an
issue of shares in exchange for shares in another company). All non-cash
movements would need to be taken into account when calculating the cash
movement.
Example:
The statements of financial position of Company P at 1 January and 31
1 January 20X9 31 December 20X9
N N
Equity shares 600,000 750,000
Share premium 800,000 1,100,000
There was a 1 for 6 bonus issue during the year funded out of retained earnings.
The bonus issue was followed later in the year by a rights issue to raise cash for
the purchase of new plan.
this
The cash obtained from issuing shares during the year is calculated as follows.
Share capital + Share premium at the end of 20X9 1,850,000

Share capital + Share premium at the beginning of 20X9 (1,400,000)
Bonus issue (600,000 u7/6 ) (100,000)
Cash obtained from issuing new shares in 20X9 350,000
If a bonus issue is funded out of share premium it can be ignored because the
balances on the two accounts are added together so the total would not be
affected.

7.3 Cash from new loans/cash used to repay loans

Cash from new loans or cash paid to redeem loans in the year can be calculated
simply by looking at the difference between the liabilities for loans and bonds at
the beginning and the end of the year.
▪ An increase in loans or bonds means there has been an inflow ofcash.
▪ A reduction in loans or bonds means there has been a payment (outflow) of
cash.
Remember to add any loans, loan notes or bonds repayable within one year
(current liability) to the loans, loan notes or bonds repayable after more than one
year (non-current liability) to get the total figure for loans, loan notes or bonds.
Loans at end of year (current and non-current liabilities)

Loans at beginning of year (current and non-current liabilities)
Cash inflow or out flow
Note: The same calculation can be applied to bonds or loan notes that the
company might have issued. Bonds and loan notes are long-term debt.
Example:
The statements of financial position of Company Q at 1 January and 31
1 January 31 December
20X9 20X9
N N
Loans repayable within 12 months 760,000 400,000
Loans repayable after 12 months 1,400,000 1,650,000
The cash flows relating to loans during the year are calculated as follows.
Loans outstanding at the end of 20X9 2,050,000

Loans outstanding at the beginning of 20X9 2,160,000
=Net loan repayments during the year (=cash outflow) 110,000

Financial reporting
7.4 Dividend payments to equity shareholders

These should be the final dividend payment from the previous year and the interim
dividend payment for the current year. The dividend payments during the year are
shown in the statement of changes in equity (SOCIE).
You might be expected to calculate dividend payments from figures for retained
earnings and the profit after tax for the year.
If there have been no transfers to the retained earnings reserve from the
revaluation reserve in the year, the equity dividend payments can be calculated
as follows:
Retained earnings reserve at the beginning of the year

Profit for the year after tax
Increase in the retained earnings reserve X
Retained earnings reserve at the end of the year
Equity dividend payments
Example:
From the following information, calculate the cash flows from investing activities
for Company X in 20X9.
Beginning of End of
20X9 20X9
N N
Share capital (ordinary shares) 400,000 500,000
1,065,000 1,685,000
Loans repayable after more than 12 months 600,000 520,000
Loans repayable within 12 months or less 80,000 55,000
for
Calculate for 20X9, for inclusion in the statement of cash flows:

the cash from issuing new shares
the cash flows received or paid for loans
the payment of dividend to ordinary shareholders.

Proceeds from new issue of shares N

Share capital and share premium:
At the end of the year (500,000 + 615,000) 1,115,000
At the beginning of the year (400,000 + 275,000) 675,000
Proceeds from new issue of shares during the year 440,000
Repayment of loans N
Loans repayable:
At the end of the year (520,000 + 55,000) 575,000
At the beginning of the year (600,000 + 80,000) 680,000
Repayment of loans during the year 105,000
Payment of dividends N
Retained earnings at the beginning of the year 390,000
Profit after taxation for the year 420,000
810,000
Retained earnings at the end of the year 570,000
Dividends paid during the year 240,000
Cashflows from financing activities can now be presented as follows.
Cash flows from financing activities N N
Proceeds from issue of shares 440,000
Repayment of loans (105,000)
Dividends paid to shareholders (240,000)
Net cash from financing activities 95,000

Financial reporting
8 CHAPTER REVIEW
Prepare extracts from a statement of cashflow
Prepare a statement of cashflow


Solutions 1
(a) In the adjustments to get from the operating profit to the cash flow from
operations, the loss on disposal of N8,000 should be added.
(b) Under the heading ‘Cashflows from investing activities’, the sale price of
the vehicle of N22,000 should be included as a cash inflow.
Workings:
Original cost of vehicle 50,000
Accumulated depreciation at date of disposal (20,000)
Net book value at the time of disposal 30,000
Therefore, net sales proceeds 22,000
Solutions 2
N
Adjustments for:
Depreciation 25,000
Interest charges 10,000
Gain on disposal of non-current asset (14,000)
81,000
Reduction in trade and other 5,000
receivables Increase in inventories (4,000)
Reduction in trade payables (6,000)
76,000
Taxation paid (17,000)
Cash flows from operating activities 49,000

Financial reporting
Solutions 3
Property, plant and equipment purchases N
At cost or valuation at the end of the year 381,000
At cost or valuation at the beginning of the year 329,000
52,000
Add: Cost of assets disposed of in the year 40,000
Subtract: Asset revaluation during the year
(102,000– 67,000) (35,000)
Purchases during the year 57,000
Disposal of equipment N
At cost 40,000
Accumulated depreciation, at the time of disposal (21,000)
Net book value/carrying amount at the time of disposal 19,000
Loss on disposal 4,000
Net disposal value (= assumed cash flow) 15,000

CHAPTER
Contents
P/E ratio and earnings pershare
Calculating basic EPS
Diluted EPS
IAS 33: Presentation and disclosure requirements
Earnings per share as a performance measure
Chapter review

Financial reporting
INTRODUCTION
Aim
principles.
Detailed syllabus
statements
8 Earnings per share (IAS 33)
Calculate, discuss and account for earnings per share (EPS) in accordance with
the provisions of IAS 33.
Exam context
This chapter explains how to calculate earnings per share

„ Explain why a standard calculation of earnings per share is important
„ Calculate basic earnings per share
„ Calculate diluted earnings per share

Chapter 24: IAS 33: Earnings per share
1 P/E RATIO AND EARNINGS PER SHARE (EPS)
The need for a standard on earnings per share

IAS 33: Earnings per share
1.1 The need for a standard on earnings per share
Earnings per share

Earnings are profits available for equity (ordinary shareholders). Earnings per
share (EPS) is a measure of the amount of earnings in a financial period for each
equity share.
As its name implies, EPS is calculated as reported earnings divided by the
number of ordinary shares in issue.
Theprice/earningsratio
The price/earnings ratio (P/E ratio) is a key stock market ratio. It is a measure of
the company’s current share price (market price) in relation to the EPS. The P/E
ratio is calculated as follows:
Formula: Price earnings ratio

Market value of share
P/Eratio =
Earnings per share
The P/E ratio can be used by investors to assess whether the shares of a
company appear expensive or cheap. A high P/E ratio usually indicates that the
stock market expects strong performance from the company in the future and
investors are therefore prepared to pay a high multiple of historical earnings to
buy the shares.
EPS is used by investors as a measure of the performance of companies in
which they invest – or might possibly invest. Investors are usually interested in
changes in a company’s EPS over time – trends – and also in the size of EPS
relative to the current market price of the company’s shares.
EPS should therefore be calculated by all companies in a standard way, so that
investors can obtain a reliable comparison between the EPS and P/E ratios of
different companies.
1.2 IAS 33: Earnings pershare

The rules for calculating EPS are set out in IAS 33 Earnings per share
The concept of EPS is quite straightforward. It is simply the profit in the year
divided by the number of ordinary shares in that year.
IAS 33 specifies the profit figure that should be used and explains how to
calculate the appropriate number of shares when there have been changes in
share capital during the period under review.

Financial reporting
IAS 33 also describes the concept of dilution which is caused by the existence of
potential ordinary shares.
Each of these issues is dealt with in later sections.
Objective of IAS 33
The objective of IAS 33 is to set out principles for:
‰ the calculation of EPS; and
‰ the presentation of EPS in the financial statements.
The purpose of standardising the calculation and presentation of EPS is to make
it easier for the users of financial statements to compare the performance of:
‰ different entities in the same reporting period; and
‰ the same entity for different reporting periods overtime.
Scope of IAS 33
IAS 33 applies only to publicly-traded entities or those which are about to be
publicly traded. A publicly-traded entity is an entity whose shares are traded by
the investing public, for example on a stock exchange.
Most publicly-traded entities prepare consolidated financial statements as well as
individual financial statements. When this is the case, IAS 33 requires disclosure
only of EPS based on the figures in the consolidated financial statements.
Definition
Definition
An ordinary share is an equity instrument that is subordinate to all other classes
of equity instruments.
The ordinary shares used in the EPS calculation are those entitled to the residual
profits of the entity, after dividends relating to all other shares have been paid. As
stated earlier, if you are given an examination question on this topic, preference
shares are not ordinary shares because they give more rights to their holders than
ordinary shares.
Preference shares and EPS

Preference shares are not ordinary shares. Since EPS is a measure of earnings
per ordinary share in a financial year, preference shares are excluded from the
number of shares.
The dividends paid to preference shareholders must therefore be excluded from
the total earnings for the period. A broad definition of ‘earnings’ is therefore profit
after tax less preference dividends paid.

Basic and diluted earnings per share

IAS 33 requires entities to calculate and present basic earnings per share and
diluted earnings per share.
Diluted EPS and basic EPS will usually differ when there are potential ordinary
shares in existence.
Definition
A potential ordinary share is a financial instrument or other contract that may
entitle its holder to ordinary shares at some time in the future.
IAS 33 gives the following examples of potential ordinary shares:

▪ financial liabilities or equity instruments that are convertible into new
ordinary shares at some time in the future (convertible debentures,
convertible preference shares);
▪ share options and warrants. Options and warrants are financial instruments
that give the holder the right (but not the obligation) to purchase new ordinary
shares at some time in the future, at a fixed price;
▪ shares that will be issued if certain contractual conditions are met, such as
contractual conditions relating to the purchase of abusiness.
The chapter explains the calculation of basic EPS and then the calculation of
diluted EPS.

Financial reporting
2 CALCULATING BASIC EPS
Basic EPS
Total earnings
Changes in the number of shares during a period
Issue of shares at full market price
Bonus issues of shares
Rights issues of shares
2.1 Basic EPS

The calculation of the basic EPS is as follows:
Formula: Basic EPS

Netprofit (or loss) attributable to ordinary shareholders during a period
weighted average number of shares in issue during the period
Basic EPS is calculated by dividing the profit (or loss) attributable to ordinary
shareholders of the parent (commonly referred to as total earnings) by the
weighted average number of ordinary shares in issue during the period. In
addition, basic EPS must also be calculated for the profit or loss from continuing
operations when that figure is presented. Both of these figures must be presented
in the statement of comprehensive income. When there is a loss, EPS is negative.
The number of shares used in the calculation is the weighted average number of
shares in issue during the period. Changes in share capital during a period must
be taken into account in arriving at this number. IAS 33 provides guidance on how
to do this.
2.2 Total earnings

The aim of the EPS calculation is to show the profit attributable to ordinary
shareholders. Therefore, all other claims on the profit for the year must be taken
into account.
The total earnings figure is the profit or loss attributable to ordinary shareholders.
This is the profit after tax for the year after excluding the earnings attributable to
non-controlling interests (if any). Therefore, total earnings include any income
from associates (i.e., any share of profits or losses of associates).
It may be necessary to adjust this figure for preference dividends.
Preference shares
Preference shares must be classified as equity or liability in accordance with the
rules in IAS 32: Financial Instruments: Presentation.
If a class of preference shares is classified as equity, any dividend relating to that
share is recognised in equity. Any such dividend must be deducted from the profit
or loss from continuing operations as stated above.

If a class of preference shares is classified as liability, any dividend relating to that

share is recognised as borrowing cost in the statement of profit or loss. It is already
deducted from the profit or loss from continuing operations and no further
adjustment need be made.
In the year ended 31 December Year 1, X Ltd had the following results:
N
Profit from continuing operations 3,000,000
Profit from discontinued operations 500,000
Profit attributable to ordinary share holders 3,500,000
N
N
X Ltd had 1 million ordinary shares in issue throughout the year.
X Ltd’s basic EPS calculations for the year ended 31 December Year
1 are as follows if the preference shares are classified as liabilities:
Earning Number of EPS
(N) shares (N)
Profit from continuing operations 3,000,000 1,000,000 3.0
Profit attributable to ordinary share
holders 3,500,000 3.5
X Ltd’s basic EPS calculations for the year ended 31 December Year 1
are as follows if the preference shares are classified as equity:
Earnings Number of EPS

(N) shares (N)
Profit from continuing operations
(3,000,000 – 65,000) 2,935,000 1,000,000 2.94
Profit attributable to ordinary
shareholders (3,500,000 – 65,000) 3,435,000 3.44

Financial reporting
Cumulative preference shares

There is a further complication concerning preference shares. Some preference
shares are cumulative preference shares. This means that if a company fails to
declare a preference dividend in a period the holders are entitled to receive the
missed dividend sometime in the future. In other words, their right to receive a
dividend accumulates when a dividend is not declared. If there are cumulative
preference shares in issue the dividend must be deducted from profit or loss from
continuing operations regardless of whether the dividend has been declared or
not.
Example: Cumulative preference shares

In the year ended 31 December Year 1, Entity G made profit after tax from
N
N capital in
N N
Entity G had 1 million ordinary shares in issue throughout the year.
Entity G’s basic EPS for the year ended 31 December Year 1 is calculated as follows:
Net profit (or loss) attributable to ordinary shareholders during a
EPS = period
= N N = N

2.3 Changes in the number of shares during a period

IAS 33 gives guidance on how to incorporate changes in share capital during a
period into the calculation of the weighted average of shares that must be used in
the EPS calculation.
There are different ways in which the number of shares may change:
‰ Issues for full consideration (issue (or redemption) of shares at a full market
price).
‰ Issues for no consideration (issue (or redemption) of shares with no change
in net assets), for example:
x bonus issues;
x share splits (where one share is split into several others);
x reverse share splits;
x bonus elements in other issues (see later discussion on rights
issues).
‰ Rights issues (issue of shares for consideration but at less than the full
market price of the share).
IAS 33 gives guidance on each of these.
Overall approach
At this point we will provide an overall approach designed to enable you to deal
with complicated situations where there has been more than one capital change
in the period.
Step 1: Write down the number of shares at the start of the year.
Step 2: Write down the date of the first capital change and the number of shares
in existence after that capital change. Repeat this step until all capital changes
have been dealt.
Step 3: Multiply each number of shares by the fraction of the year that it was in
existence.
Step 4: Add up the results from step 4 to give the weighted average number of
shares.
Note: If any capital change is due to or contains a bonus issue multiply each
preceding number of shares by the bonus fraction.
This will not make much sense to you at first but it will become clear as you study
later examples.

Financial reporting
Example: Time apportionment to find weighted average

On 1 January a company had 5,000,000 ordinary shares in issue.
On 1 April, 1,000,000 new shares were issued.
On 1 July an extra 1,000,000 shares came into existence
On 1 November 500,000 more shares were issued.
(All issues were at full market price – the implication of this will be explained in
more detail in the next section).
The weighted average number of shares is calculated as follows.
Numberof Time average

Date shares factor number
1 January to 31 March 5,000,000 u3/12 1,250,000
New issue on the 1 April 1,000,000
1 April to 30 June 6,000,000 u3/12 1,500,000
New issue on the 1 July 1,000,000
1 July to 31 October 7,000,000 u4/12 2,333,333
New issue on the 1 November 500,000
1 November until 31 December 7,500,000 u2/12 1,250,000
6,333,333

2.4 Issue of shares at full marketprice

The consideration received is available to boost earnings. Therefore, the shares
are included from the date of issue to ensure consistency between the numerator
(top) and denominator (bottom) of the EPS calculation.
As explained above, the starting point for the weighted average number of shares
is the number of shares in issue at the beginning of the period. This is then adjusted
for any shares issued during the period and a time weighting factor must then be
applied to each figure.
There is no adjustment to comparatives resulting from an issue at full price.
Example: Issue of shares at full market price Company

A has a financial year ending 31 December.
On 1 January Year 1 there were 6,000,000 ordinary shares in issue.
On 1 April, it issued 1,000,000 new shares at full market price.
in N
EPS in Year 1 is calculated as follows.
Numberof
Date
1 January to 31 March 6,000,000 u3/12 1,500,000
New issue on the 1 April
5,250,000
1 April to 31 December
6,750,000
= N = N
Practice question
Company B has a financial year ending 31 December.
On 1 January Year 3, there were 9,000,000 ordinary shares in issue.
On 1 May, Company B issued 1,200,000 new shares at full market price.
On 1 October, it issued a further 1,800,000 shares, also at full market
price.
in N
Calculate the EPS for the year to 31 December Year 3.

Financial reporting
2.5 Bonus issues of shares

A bonus issue of shares (also called a scrip issue or a capitalisation issue) is an
issue of new shares to existing shareholders, in proportion to their existing
shareholding, for no consideration. In other words, the new shares are issued
‘free of charge’ to existing shareholders.
The new shares are created by converting equity reserves in the statement of
financial position, often some or all of the share premium account, into ordinary
share capital.
No cash is raised from a bonus issue, therefore is no earnings boost from the
issue. Bonus issued shares are treated as if they have always been in issue.
The new number of shares (i.e. the number of shares after the bonus issue) can
be found by multiplying the number of shares before the bonus issue by the bonus
issue fraction.
The bonus issue fraction is
Formula: Bonus issue fraction

Number of shares in holding after the bonus issue
Number of shares in holding before the bonus issue
Example: Bonus fraction

A company has 4,000,000 shares ini ssue. It made a 1 or 4 bonus issue
The bonus fraction is
Number of shares in holding after the bonus issue
Number of shares in holding before the bonus issue
Number of shares in issue after the bonus issue:
The above example is very straightforward, but it illustrates an approach of

wider applicability.

Example: Bonus issue

Company C has a 31 December financial year end. On 1January
Year 5 it has 4,000,000 shares in issue. On1July Year 5 it made a 1
for 4 bonus issue.
The financial results for Company C in Year 4 and Year 5 were as follows.
Year5 Year4
Total earnings N20,000,000 N20,000,000
There were no share issues in Year 4.
Basic EPS in Year 4 was: N20,000,000/4,000,000 shares = N5per share.
could be calculated for the Year 5 financial statements as follows, by taking as
the number of shares for the current period and the previous period the total
number of shares after the bonus issue.
The weighted average number of shares in the current year (using the method
explained earlier) is calculated as:
Weighted
Number of Time Bonus average
Date shares factor fraction number
1 January to 30 June 4,000,000 × 6/12 ×5/4 2,500,000
Bonus issue on 1 July 1,000,000
1 July to 31 December 5,000,000 × 6/12 2,500,000
5,000,000
Remember that if a capital change is due to a bonus issue each preceding

must be multiplied by the bonus fraction.
This must be done so that the new shares issued are not time apportioned.
The new shares are included from 1 July to 31 December so they must also
be included in the period(s) before this.
There is a much easier way to arrive at the number of shares in this
example. It is simply the number in issue at the end of the year. However,
this only works if the bonus issue is the only capital change in a year. In
such cases do it this way but if there is more than one capital change in a
period you must use the longer method shown above.
Basic EPS in Year 5 is: N20,000,000/5,000,000shares = N4 per share.

Financial reporting
In the above example nothing changed between Year 4 and Year 5 except for
the number of shares yet the EPS figures calculate indicate a deterioration from
N5 per share to N4 per share.
Comparatives
There is no time apportionment for a bonus issue. This means that all
comparative figures must be restated into the same terms to take account of the
bonus. Unless a suitable adjustment is made to the EPS calculation, the
comparison of EPS in the current year (after the bonus issue) with EPS in the
previous year (before the bonus issue) would be misleading.
In order to ensure that the EPS in the year of the bonus issue is comparable with
the previous year’s EPS, IAS 33 requires that the weighted average number of
shares should be calculated as if the bonus shares had always been in issue.
This means that:
‰ the current period’s shares are adjusted as if the bonus shares were issued
on the first day of the year; and
‰ the comparative EPS for the previous year is restated on the samebasis.
The restatement of the comparatives is easily achieved by multiplying it by the
inverse of the bonus fraction.
Company C made a 1 for 4 bonus issue in Year 5. .
in N =N
N = N
The figures presented in Company C’s Year 5 accounts would be:
Year5 Year4
N
Practice question
Company D has a 31 December year end and had 2,000,000 ordinary
shares in issue on 1 January Year 2.
On 31March Year 2, it issued 500,000 ordinary shares, at full market
price. On 1JulyYear 2, Company D made a 1 for 2 bonus issue.
N
N
Calculate the EPS for the year to 31 December Year 2, and the
comparative EPS figure for Year1.

2.6 Rights issues of shares

A rights issue of shares is an issue of new shares for cash, where the new
shares are offered initially to current shareholders in proportion to their existing
shareholdings.
The issue price of the new shares in a rights issue is always below the current
market price for the shares already in issue. This means that they include a
bonus element which must be taken into account in the calculation of the
weighted average number of shares. Also note that any comparatives must be
restated by multiplying them be the inverse of the rights issue bonus fraction.
The rights issue bonus fraction is calculated as follows:
Formula: Rights issue bonus issue fraction

Actual cum rights price
Theoreticalex rights price
The actual cum-rights price is the market price of the shares before the rights
issue.
The theoretical ex-rights price is the price that the shares ought to be, in
theory, after the rights issue. It is a weighted average price of the shares before
the rights issue and the new shares in the rights issue.
The calculation of the theoretical ex rights price looks a little complicated at first
but it is always done this way. This is demonstrated in the following example.

Financial reporting
Example:
Company E had 3,600,000 shares in issue on 1 January Year 2.
It made a 1for 4 rights issue on1JuneYear 2, at a price of N40 per share. (After
the rights issue, there will be 1 new share for every 4 shares previously in issue).
The share price just before the rights issue was N50.
Total earnings in the financial year to 31 December Year 2 were N25,125,000.
The reported EPS in Year 1 was N6.4.
EPS for the year to 31 December Year 2 and the adjusted EPS for Year 1 for
comparative purposes are calculated as follows:
Theoretical ex-rights price N
4 existing shares have a ‘cum rights’ value of (4×N50) 200
1 new share is issued for 40
5 shares after the issue have a theoretical value of 240
Therefore, the theoretical ex-rights price= N240/5= N48
Rights issue bonus fraction:
Actual cum rights price/Theoretical ex rights price = 50/48.
Weighted average number of shares
Weighted
average
Numberof Time Rights numberof
Date shares factor fraction shares
1 January to 31 May 3,600,000 × 5/12 × 50/48 1,562,500
Rights issue on 1 June 900,000
1 June to 31 December 4,500,000 × 7/12 2,625,000
4,187,500
Calculation of EPS
EPS Year 2= N25,125,000/4,187,500= N6 per share
Comparative EPS in Year 1= N6.4×(N48/N50) = N6.14 per
share

Practice question
Company F had 3 million ordinary shares in issue on 1 January Year 7.
N
N
An issue of 400,000 shares at full market price was then made on 1
August Year 7.
N
N
Required
Calculate the EPS for the year to 31 December Year 7, and the adjusted
EPS for Year 6 for comparative purposes.

Financial reporting
3 DILUTED EPS
The meaning of dilution

IAS 33 and diluted EPS
Diluted EPS: convertible preference shares and convertible bonds
Diluted EPS: options and warrants
Potential ordinary shares that are not dilutive
3.1 The meaning of dilution

‘Dilution’ means ‘watering down’ or ‘reduction in strength’.
An entity might have potential ordinary shares in issue. There is a possibility that
these will become actual ordinary shares at some time in the future.
For example, if an entity has issued some convertible bonds or convertible
preference shares, these might be converted into ordinary shares at some time in
the future.
Similarly, holders of share options or warrants might exercise their right at a
future date to subscribe for new shares at a fixed price.
If potential shares become actual ordinary shares, the earnings figure will be
shared with a larger number of ordinary shares. This would dilute the EPS.
3.2 IAS 33 and diluted EPS

IAS 33 requires publicly-traded companies to calculate a diluted EPS in addition
to their basic EPS for the current year (with a comparative diluted EPS for the
previous year), allowing for the effects of all dilutive potential ordinary shares.
Potential ordinary shares might not dilute the EPS. The diluted EPS calculation
only includes potential ordinary shares that would be dilutive. Note: potential
ordinary shares are ‘dilutive’ when there might have been a reduction or ‘dilution’
in EPS if they had been actual ordinary shares during the financial period.
Diluted EPS is calculated by adjusting the earnings and number of shares figures
used in the basic EPS calculation.
Earnings is adjusted to remove the effect of dividends or interest that have been
recognised during the year for the potential ordinary shares, and for any other
income or expense that would alter as a result of the conversion of the potential
ordinary shares into actual ordinary shares.
The main items of dividend or interest to adjust for are dividends on convertible
preference shares and interest on convertible debentures (convertible bonds).
The dividend or interest reduces total earnings. However, if they had already been
converted into ordinary shares (and the calculation of diluted EPS is based on this
assumption) the dividends or interest would not have been payable. Total
earnings would therefore have been higher. To calculate the diluted EPS, total
earnings are adjusted to allow for this.

The weighted average number of shares must also be adjusted. The method of
making this adjustment is different for:
‰ convertible bonds or convertible preference shares; and
‰ share options or warrants.
3.3 Diluted EPS: convertible preference shares and convertible bonds

When there are convertible bonds or convertible preference shares, diluted EPS
is calculated as follows, by making adjustments to total earnings and the number
of shares in issue used in the basic EPS calculation.
Total earnings
Total earnings are adjusted because the entity would not have to pay the
dividend or interest on the convertible securities.
‰ For convertible preference shares, add back the preference dividend paid
in the year. Total earnings will be increased by the preference dividend
saved.
‰ For convertible bonds, add back the interest charge on the bonds in the
year less the tax relief relating to that interest. Total earnings will increase
by the interest saved less tax.
Number of shares
The weighted average number of shares is increased, by adding the maximum
number of new shares that would be created if all the potential ordinary shares
were converted into actual ordinary shares.
The additional number of shares is normally calculated on the assumption that
they were in issue at the beginning of the year.

Financial reporting
Example: Diluted EPS (convertible bonds)

Company G has12,000,000 ordinary shares and N4,000,000 5% convertible
bonds in issue.
As at 31 December Year 2, there have been no new issues of shares or bonds
for several years.
The bonds are convertible into ordinary shares in Year 3 or Year 4, at the
following rates:
At 30 shares for every N100 of bonds if converted at 31 December Year 3
At 25 shares for every N100 of bonds if converted at 31 December Year 4
Total earnings for the year to 31December Year 2 were N36,000,000.
Tax is payable at a rate of 30% on profits.
The basic EPS and diluted EPS for Year 2 are calculated as follows:
Basic EPS:
Year to 31 December Year 2: N36,000,000/12 million= N3 per share
Diluted EPS:
Number of
shares Earnings(N) EPS(N)
Basic EPS figures 12,000,000 36,000,000 3
Dilution:
Number of shares 1,200,000
4,000,000 u30/100
Add back interest:
5%u N4,000,000 200,000
Less tax at 30% (60,000)
Adjusted figures 13,200,000 36,140,000 2.74
Diluted EPS: N36,140,000/13.2 million =N2.74 per share
Note: The number of potential shares is calculated using the conversion rate of
30 shares for every N100 of bonds, because this conversion rate produces more
new shares than the other conversion rate, 25 shares for every N100 of bonds.

New issue of convertibles in the year

If new convertibles are issued during the course of the year, the additional
number of shares and the earnings adjustment are included only from the time
that the convertibles were issued.
Example: Diluted EPS (New issue of convertibles in the year)

Company H has 10,000,000 ordinary shares in issue.
There has been no new issue of shares for several years. However, the company
issued N2,000,000 of convertible 6% bonds on 1 April Year 5.
These are convertible into ordinary shares at the following rates:
On 31 March Year 10 25 shares for every N100 of bonds
On 31 March Year 11 20 shares for every N100 of bonds

Tax is at the rate of 30%.
In the financial year to 31December Year 5 total earnings were N40,870,000.
TheYear 5 basic EPS and diluted EPS are calculated as

follows: Basic EPS
Year 5= N40,870,000/10,000,000= N4.087 per share
Diluted EPS:
Number of
Basic EPS figures 10,000,000 40,870,000 4.087
Dilution:
Number of shares
2 million u25/100 u9/12 375,000
Add back interest:
6%u N2,000,000u9/12 90,000
Less tax at 30% (27,000)
Diluted EPS: N40,933,000/10.375 million = N3.94 per share

Financial reporting
3.4 Diluted EPS: options and warrants

A different situation applies with share options and share warrants.
Options (warrants) are contracts issued by a company which allow the holder of
the option to buy shares off the company at some time in the future at a pre-
agreed price.
If the option holder exercises this right the number of shares would increase and
the company would receive the cash paid for the shares and this would be
available to invest in the business and in turn this would be expected to boost its
earnings. However, it is impossible to predict how total earnings will be affected
when the cash is eventually received.
This presents a problem. Including the shares in the diluted EPS calculation
without adjusting the earnings would be inconsistent but it is not possible to
adjust the earnings.
IAS 33 solves this problem in quite a neat way. The amount that would be
received on exercise of the options is treated as cash received from selling
shares at full price with the remaining shares having been given away. The
shares sold at full price are not considered to be dilutive as any cash would be
invested to earn the same return as earned in the period. It is only the free
shares that are dilutive.
The following steps must be taken:
Step 1: Calculate the cash that would be received if the options are exercised.
Step 2: Calculate the number of shares that could be sold at full market price to
raise the same amount of cash. (Divide the figure from step 1 by the average
share price in the period).
Step 3: Identify the number of shares that will be issued if all the options are
exercised.
Step 4: Subtract the number of shares in step 2 from the number at step 3. These
shares are treated as having been given away for free and is added to the existing
number of shares in issue, to obtain the total shares for calculating the diluted
EPS.

Example: Diluted EPS (options)

N It has
5,000,000 ordinary shares in issue.
There are outstanding share options on 400,000 shares, which can be exercised
future N
in N
The diluted EPS for Year 3 may be calculated as follows:
Step 1: Cash proceeds from exercise of the options
400,000u N25 N10,000,000
Step 2: Divide by the average share price in the period
N40
Shares issued at full price 250,000
Step 3 Number of shares issued on exercise of the
option 400,000
Step 4 Shares issued for free 150,000
Diluted EPS calculation

Number of
Basic EPS figures 5,000,000 25,000,000 5
Dilution:
Number of shares 150,000
N =N
Options are only included in the diluted EPS calculation if the average share
price in the year is greater than the exercise price of the option. If this were not
the case the option would not be exercised. (Nobody would pay an exercise price
of N100 for something worth only N80).
‰ When the exercise price of the option is less than the share price they are
said to be in themoney.
‰ When the exercise price of the option is more than the share price they are
said to be out of the money.
In the money options are always dilutive. Out of the money options are always
not dilutive (or antidilutive as IAS 33 describes them).

Financial reporting
3.5 Potential ordinary shares that are not dilutive

Only dilutive potential ordinary shares are included in the dilutive EPS
calculation.
When there are several types of potential ordinary share in issue, they should be
ranked in order of dilution, with the most dilutive potential ordinary shares ranked
first. In order to carry out the ranking the earnings per incremental share is found
for each potential ordinary share. This is the earnings adjustment that would be
necessary divided by the number of shares that would come into being if the
share were included in the calculation of diluted EPS.
Note that in the money options always rank first as they increase the number of
shares in the calculation without affecting the earnings.
A diluted EPS should then be calculated in stages, taking in one potential
ordinary share at a time, to establish whether any of them are not dilutive.
The following example illustrates the technique.
Example: Order of dilution

The following information relates to Company K for the year ended 31 December
Year 5.
Number of ordinary shares in issue 5,000,000

Reported earnings in the year N15,000,000
Average market price of shares during
The year N80
Potential ordinary shares:

Options 600,000 options, with
an exercise price of N60
4% convertible bond: N5,000,000 Each bond is convertible in Year
10 into ordinary shares at the
rate of 40 newshares for
every
N100ofbonds
100,0007% convertible preference Each preference share is
shares of N10 each convertible in Year 9 into
ordinary shares at the rate of 1
ordinary share for every 20
preference shares
Tax rate = 30%
Diluted EPS for the year to 31 December Year 5 can be calculated as follows.

Example (continued): Order of dilution

If all the options are exercised, the cash received will be 600,000×N60=
N36,000,000.
This would purchase 450,000 shares (N36,000,000/N80) at the average market
price in Year 5.
The dilutive increase in the number of shares would therefore be (600,000 –
450,000) = 150,000.
Increase Increase in Earnings per
in number of incremental
earnings. shares share Ranking
N N
Option 0 150,000 0.00 1st
Convertible bonds
4%×N5,000,000 200,000
less tax 30% (60,000)
140,000
N5,000,000u40/100 2,000,000
140,000 2,000,000 0.07 2nd
Preference shares
7% × N1,000,000 70,000
100,000 u1/20 5,000
70,000 5,000 14.0 3rd
Diluted EPS is calculated as follows (taking these three dilutive potential
ordinary shares in order of their ranking):
Number of
Earnings shares EPS
N N
As reported, basic EPS 15,000,000 5,000,000 3.000
Options 0 150,000
Diluted EPS, options
only 15,000,000 5,150,000 2.913 Dilutive
Convertible bonds 140,000 2,000,000

Diluted EPS, options
and convertible bonds 15,140,000 7,150,000 2.12 Dilutive
Convertible preference
shares 70,000 5,000
Diluted EPS, options Not
and all convertibles 15,210,000 7,155,000 2.13 dilutive
The convertible preference shares are not dilutive, and the reported diluted EPS
should be N2.12 (and not N2.13).

Financial reporting
4 IAS 33: PRESENTATION AND DISCLOSURE REQUIREMENTS
Presentation requirements
Alternative measures of earnings per share
4.1 Presentation requirements

The following must be presented in the statement of comprehensive income:
‰ basic EPS and diluted EPS for profit (or loss) attributable to the ordinary
shareholders; and
‰ basic EPS and diluted EPS for profit (or loss) from continuing operations
attributable to the ordinaryshareholders.
For consolidated accounts, this is the EPS and diluted EPS attributable to the
owners of the parent company.
The basic EPS and diluted EPS should be presented with equal prominence for
all the periods presented (the current year and the previous year). These figures
are presented at the end of the statement of profit or loss.
If the entity presents a separate statement of profit or loss:
‰ the EPS and diluted EPS should be shown in this statement, and
‰ not in the statement of profit or loss and other comprehensiveincome.
The basic and the diluted EPS should be presented, even if it is a negative figure
(i.e., even if it is a loss per share).

IAS 33 also requires disclosure in a note to the financial statements of the
following:
‰ The total amounts used as the numerators (= total earnings figures) to
calculate the basic EPS and diluted EPS, and a reconciliation of these
numerator figures to the profit or loss for the period
‰ The total amounts used in the denominators (= weighted average number
of shares) to calculate the basic EPS and diluted EPS, and a reconciliation
of these two denominator figures to each other.
4.3 Alternative measures of earnings per share

IAS 33 allows an entity to disclose an alternative measure of EPS in addition to
the EPS calculated in accordance with IAS 33. For example, EPS could be
calculated after adjusting earnings for large and unusual items.
If an alternative EPS figure is presented, IAS 33 states that:
‰ a reconciliation must be shown between the earnings figure used in the
alternative measure and the amounts shown in the statement of profit or
loss

‰ the alternative EPS must use the same weighted average number of
shares as the IAS 33 calculation
‰ basic and diluted EPS should both be disclosed with equal prominence,
and
‰ the alternative figure must only be shown in the notes, not on the face of
5 EARNINGS PER SHARE AS A PERFORMANCE MEASURE
Earnings per share and trends

Limitations of earnings per share
5.1 Earnings per share and trends

Investors and their advisers pay close attention to an entity’s net profit for the
period. However, profit for the period can include large and unusual items and
this make it difficult for users to assess trends in the profit figure or to use the
current year’s profit to predict an entity’s performance in future years.
The trend (improvement or deterioration) in an entity’s published EPS figure can
sometimes be a more reliable indicator of future performance. There are a
number of reasons for this.
‰ The standard version of both basic and diluted EPS is based on profit from
continuing operations. This means that the results of discontinued
operations (which may distort total profit) are excluded.
‰ An entity may also choose to present one or more alternative versions of
EPS. These normally exclude large or unusual items so that EPS is based
on ‘normal’ recurring earnings.
‰ EPS measures an entity’s performance from the viewpoint of investors. It
shows the amount of earnings available to each ordinary shareholder. This
means that EPS takes the effect of preference dividends (if any) into
account. It also takes share issues into account.
‰ Diluted EPS can provide an ‘early warning’ of any changes to an investor’s
potential return on their investment due to future share issues.
5.2 Limitations of earnings pershare

EPS is probably the single most important indicator of an entity’s performance. It
is a very useful measure when it is used as the starting point for a more detailed
analysis of an entity’s performance.
However, EPS can have serious limitations:
‰ Not all entities use the same accounting policies. It may not always be
possible to make meaningful comparisons between the EPS of different
entities.
‰ EPS does not take account of inflation, so that growth in EPS over time
might be misleading.
‰ EPS measures an entity’s profitability, but this is only part of an entity’s
overall performance. An entity’s cash flow can be just as important as its
profit (and more essential to its immediate survival). Changes in the value
of assets (holding gains) can also be an important part of performance for
some entities.
‰ Diluted EPS is often described as an ‘early warning’ to investors that the

return on their investment may fall sometime in the future. However, diluted
EPS is based on current earnings, not forecast earnings. This means that it
may not be a reliable predictor of future EPS.
One of the main problems with EPS can be the way that it is used by investors and
others. Users often rely on EPS as the main or only measure of an entity’s
performance. Management know this and try to make EPS appear as high as
possible. They may attempt to manipulate the figure by using ‘creative accounting’.
They may also make decisions which increase EPS in the short term but which
damage the entity in the longer term.
The problem is mitigated in a number of ways.
‰ Rules in IFRS require disclosure of significant accounting policies and the
standardisation of the calculation of IFRS. This means that users have
access to information about the basis of the calculation of the EPS figure.
‰ It is difficult to imagine that a company would publish EPS information
prepared by anyone other than a qualified accountant. Users can take
comfort from the fact that members of ICAN are governed by a strict ethical
code which, if followed, would prevent the use of creative accounting
techniques. Members of other institutes are bound by ethicalrequirements.
‰ The problem could be further mitigated by educating users not to rely on
this single measure. Note that investment professionals would not base
advice and decisions on a single measure.
6 CHAPTER REVIEW
Explain why a standard calculation of earnings per share is important
Calculate basic earnings per share
Calculate diluted earnings per share

Date
1 January to 30 April 9,000,000 3,000,000
New issue on 1 May 1,200,000
1 May to 30 September 10,200,000 4,250,000
New issue on 1 October 1,800,000
1 October to 31 December 12,000,000 3,000,000
10,250,000
= N =N
Notes
The first new share issue is in May, after 4 months. Therefore, the number of
shares at the beginning of the year is given a time factor of × 4/12.
There are 5 months between the two share issues, therefore the time factor to
apply to the number of shares after the first issue is ×5/12.
The total number of shares in issue from 1October to the end of the year (three
months) is12,000,000. These are given a time weighting of × 3/12.
Solution
The weighted average number of shares in Year 2 is calculated as follows.
Weighted
Numberof Time Bonus average
Date shares factor fraction number
1 January to 31 March 2,000,000 × 3/12 × 3/2 750,000
Issue at full price on 31 March 500,000
1 April to 30 June 2,500,000 × 3/12 × 3/2 937,500
Bonus issue on 1 July 1,250,000
1 July to 31 December 3,750,000 × 6/12 1,875,000
3,562,500
in = N = N
N × = N

Financial reporting
Solution
After the rights issue, there will be 1 new share for every 2 shares previously in
issue
N
×N
existing shares have a ‘cumrights’ value of 1

new share is issued for
shares after the issue have a theoretical value of
= N =N
Actual cum rights price/Theoretical ex rights price = 50/40

Weighted average number of shares
Date shares factor fraction shares

1 January to 31 March 3,000,000 ×3/12 ×50/40 937,500
Rights issue on 1 April 1,500,000
1 April to 31 July 4,500,000 × 4/12 1,500,000
Issue at full price on 1 August 400,000
1 August to 31 December 4,900,000 × 5/12 2,041,667
4,479,167
Calculation of EPS
= N = N
=N × =N

CHAPTER
Contents
Purpose of financial ratio analysis
Return on capital, profitability and asset turnover
Working capital efficiency ratios
Liquidity ratios
Debt ratios
Investor ratios
Limitations of interpretation techniques
Earnings per share as a performance measure
Using cash flow information
Specialised, non-for-profit and public sector entities
Chapter review

Financial reporting
INTRODUCTION
Aim
Detailed syllabus
E Analysis and interpretation of financial statements
1 Understanding various types of analyses that financial statements may be
subjected to and ratios used in the analysis
a Identify and discuss types of analyses and interpretation of financial
statements.
b Discuss various aspects of financial position and performance that may be
assessed (profitability, liquidity/solvency, gearing, investors’ returns)
through the analyses and interpretation of financial statements.
c Define ratio, identify and calculate various types of ratios used in the
assessment of financial position and performance of a business entity.
d Analyse and interpret computed ratios and assess the current period
financial position and performance of a business entity in comparison to:
i its prior period;
ii another given entity for the same period; and
iii industry average for the same period.
e Analyse and interpret computed ratios and assess the current period
financial position and performance of a simple group (one subsidiary and
associate) in comparison to:
i its prior period,
ii another given simple group entity for the same period and
iii industry average for the same period.
f Discuss the use of statement of cash flows in assessing liquidity and
compare its usefulness with that of a statement of profit or loss and other
comprehensive income when assessing liquidity and going concern of a
business entity.

Chapter 25: Analysis and interpretation of financial accounts
E Analysis and interpretation of financial statements (continued)

1 Understanding various types of analyses that financial statements may be
subjected to and ratios used in the analysis (continued)
g Explain the use of earnings per share (EPS) in assessing the performance
of corporate entities in the capital market, especially capital market reaction
to earnings announcement.
h Where necessary, write reports as may be required when analysing and
interpreting the financial position and performance of a business entity and
simple group, drawing conclusions, making recommendations and giving
advice from the perspectives of different stakeholders.
2 Limitations of analyses and interpretation of financial statements
a Discuss the limitations of historic financial information in the analyses and
interpretation of financial statements.
b Explain how financial statements may be manipulated and discuss the
impact of window dressing and creative accounting on calculated ratios and
how they can distort analyses and interpretation of financial statements.
c Explain how analyses and interpretation of financial statements of
specialized and not-for-profit organizations differ from those of profit-
oriented organizations.
d Explain why earnings per share (EPS) trend may be a better indicator of
performance when compared with a company’s profit trend and discuss the
limitations of using EPS as a performance measure.
e Explain why and how the use of consolidated financial statements might
limit analyses and the use of interpretation techniques.
f Discuss the use of other information, including non-financial information
relevant to the assessment of an entity’s performance.
Exam context
This chapter explains the purpose of interpretation and the use of common financial ratios
and cash flow information.
It also explains the limitations inherent in the interpretation of financial statements.

„ Calculate and interpret return on capital employed and similar ratios
„ Calculate and interpret profitability ratios, working capital ratios, liquidity ratios, debt
ratios and gearing ratios
„ Analyse performance of a company from information provided
„ Explain the limitations of financial statements and interpretation

Financial reporting
1 PURPOSE OF FINANCIAL RATIO ANALYSIS
Financial statement analysis

Using ratios: comparisons
Categories of financial ratios
Users of the financial statements and their information needs
1.1 Financial statement analysis

There is no single definition of financial statement analysis. One possible definition is
as follows.
Definition
Financial statement analysis is the process of understanding the risk and
profitability of a firm through analysis of reported financial information, by using
different accounting tools and techniques.
The above definition refers to accounting tools and techniques. Ratios are one
suchtool.
Financial statements are used to make decisions. They are used by shareholders
and investors, and also by lenders, as well as by management. The financial
statements contain a large number of figures, but the figures themselves do not
necessarily have much meaning to a user of the financial statements. However,
the figures can be analysed and interpreted by calculating financial ratios.
Financial ratios can help the user of the financial statements to assess:
‰ The financial position of the entity, and
‰ Its financial performance
1.2 Using ratios: comparisons

Financial ratios can be used to make comparisons:
‰ Comparisons over a number of years. By looking at the ratios of a company over
a number of years, it might be possible to detect improvements or deterioration in
the financial performance or financial position of the entity. Ratios can therefore be
used to make comparisons over time, and to identify changes or trends
‰ Comparisons with the similar ratios of other, similar companies for the same
period.
‰ In some cases, perhaps, comparisons with ‘industry average’ ratios.

1.3 Categories of financial ratios

The main financial ratios can be classified as:
‰ Financial performance: return on capital, profitability and use of assets
‰ Working capital ‘turnover’ratios
‰ Liquidity ratios
‰ Debt ratios
‰ Investor ratios.
1.4 Users of the financial statements and their information needs

IAS 1 defines general purpose financial statements.
Definition
General purpose financial statements (referred to as ‘ financial statements’)
are those intended to meet the needs of users who are not in a position to require
an entity to prepare reports tailored to their particular information needs.
Some users (including management and perhaps lenders are in a position to

require the preparation of tailored reports. However, there are several groups of
people who are not in this position and may use general purpose financial
statements:
‰ investors and potential investors;
‰ lenders;
‰ employees;
‰ suppliers;
‰ customers;
‰ government and government agencies;
‰ the genera lpublic.
All these groups are interested in financial performance, financial position and
cash flows, but some users are mainly interested in performance and profitability,
while others may be more interested in liquidity and gearing or other matters.

Financial reporting
For example:
‰ A private investor needs to know whether to continue to hold shares or to
sell them. He or she will tend to be most interested in profitability ratios
(such as gross and net profit margin and return on capital employed) and
investor ratios (such as earnings per share, dividend cover and price
earnings ratio).
‰ A potential acquirer needs information about an entity’s profitability and
probably also information about whether or not the entity is managed
efficiently. The acquirer’s management is likely to focus on profit margins,
return on capital employed, asset turnover and working capital ratios.
‰ A bank that has been approached to lend money to an entity needs to know
whether it will receive interest payments when these are due and whether
the money that it lends will eventually be repaid. A bank manager will
normally be most interested in cash flows and liquidity ratios (current ratio,
acid test ratio) gearing and interest cover. A potential lender will also be
interested in predicting future performance as without sales there will be no
cash.
Any analysis should focus on the needs of the user. What do they need to know?
What are they interested in? What decision do they need to make?
2 RETURN ON CAPITAL, PROFITABILITY AND AS SET TURN OVER
Return on capital employed

Return on shareholder capital
Return on assets
Analysing return: profitability and asset utilisation
Profit/sales ratio (and cost/sales ratios)
Asset turn over ratio
Percentage annual growth in sales
The aim of ‘profitability ratios’ is to assess the financial performance of a profit-

making entity and the return that it makes on the capital invested.
2.1 Return on capital employed
Profit-making companies should try to make a profit that is large enough in
relation to the amount of money or capital invested in the business. The most
important profitability ratio is probably return on capital employed or ROCE.
For a single company:
Profit before interest and taxation

(Sharecapitalandreserves+long-termdebtcapital X100%
+ preference share capital)
Capital employed is the share capital and reserves, plus long-term debt capital
such as bank loans, bonds and loan stock.
Where possible, use the average capital employed during the year. This is
usually the average of the capital employed at the beginning of the year and end
of the year.
Example: Return on capital employed

The following figures relate to Company X for Year 1.
1 January
Year 1
N Year 1
N
Bank loans 200,000 500,000
1,000,000 1,400,000
N
Income tax expense (65,000)
N ROCE
ROCE = 240,000(W1)/1,200,000(W2)u100=20%
W1 Profit before interest and tax N
Add back interest deducted 30,000
Profit before interest and tax 240,000
W2 Capital employed N
Capital employed at the beginning of the year 1,000,000
Capital employed at the end of the year 1,400,000
2,400,000
÷2
Average capital employed 1,200,000
This ROCE figure can be compared with the ROCE achieved by the
company in previous years, and with the ROCE achieved by other
companies, particularly competitors.
Groups of companies and ROCE

To calculate the ROCE for a group of companies, it is necessary to decide what
to do with any non-controlling interest (minority interest). Since capital employed
includes all the debt capital in the group, it makes sense to include the non-
controlling interest (minority interest) in the capital employed.
ROCE should therefore be measured as profit before interest and tax as a
proportion of total capital employed, including the non-controlling interest.

2.2 Return on shareholder capital

Return on shareholder capital (ROSC) measures the return on investment that
the shareholders of the company have made. This ratio normally uses the values
of the shareholders’ investment as shown in the statement of financial position
(rather than market values of the shares).
Profit after taxation and preference dividend

=
Share capital and reserves
The average value of shareholder capital should be used if possible. This is the
average of the shareholder capital at the beginning and the end of the year.
Profit after tax is used as the most suitable measure of return for the
shareholders, since this is a measure of earnings (available for payment as
dividends or for reinvestment in the business).
Example: Return on shareholder capital

The following figures relate to Company X forYear 1.
1 January 31 December
Year 1 Year 1
N N
Shareholder capital 800,000 900,000
Bank loans 200,000 500,000
1,000,000 1,400,000
N
N ROSC
ROSC = 145,000/850,000(W2)u 100 =17.06%
W1 Shareholdercapital N
Shareholder capital at the beginning of the year 800,000
Shareholder capital at the end of the year 900,000
1,700,000
Average shareholder capital 850,000

Financial reporting
Groups of companies and ROSC

When calculating the ROSC for a group of companies, the main focus of
attention is normally the return on the investment of the shareholders in the
parent company. The ROSC should therefore be calculated as:
Formula: Return on shareholder capital of a group

Profit after taxation and non-controlling interest
= Equity attribute able to equity holders of
the parent company
The share capital and reserves should not include the non-controlling interest in
the equity reserves.
2.3 Return on assets
Profit before interest and taxation

X100%
Assets
The normal convention is to use ‘total assets’ which includes both current and
non-current assets. However, other variations are sometimes used such as non-
current assets only.
2.4 Analysing return: profitability and asset utilisation

The size of the return on capital employed, or the size of the return on
shareholders’ capital, depends on two factors:
‰ The profitability of the goods or services that the entity has sold
‰ The volume of sales that the entity has achieved with the capital and assets
it has employed: this is known as asset utilisation or asset turnover.
2.5 Profit/sales ratio (and cost/sales ratios)

The profit/sales ratio is the ratio of the profit that has been achieved for every N1
of sales.
Profit
Profit/sales ratio =
Profit/sales ratios are commonly used by management to assess financial

performance, and a variety of different figures for profit might be used.

The definition of profit can be any of the following:

‰ Profit before interest and tax
‰ Gross profit (sales minus the cost of sales) = ‘gross profit ratio’
‰ Net profit (profit after tax) = ‘net profit ratio’.
It is important to be consistent in the definition of profit, when comparing
performance from one year to the next.
The gross profit ratio is often useful for comparisons between companies in the
same industry, or for comparison with an industry average.
It is also useful to compare the net profit ratio with the gross profit ratio. A high
gross profit ratio and a low net profit ratio indicate high overhead costs for
administrative expenses and selling and distribution costs.
Example: Profit to sales ratios

The following figures relate to Company X for Year 1.
N
N
N
Profit to sales ratios are calculated as follows:
If profit is defined as profit before interest and tax:
If profit is defined as profit after interest and tax:
W1 Profit before interest and tax N

Add back interest deducted 30,000
Profit before interest and tax 240,000
It is also useful to monitor the ratio of different types of cost to sales. The
following ratios can be useful to highlight an unexpected change in a period or to
indicate a difference between the company and another in a similar industry:
‰ Cost of sales/Sales) ×100%
‰ Administration costs/Sales) ×100%
‰ Selling and distribution costs/Sales) ×100%

Financial reporting
2.6 Asset turn over ratio

The asset turnover ratio is the ratio of sales to capital employed.
It measures the amount of sales achieved during the period for each N1 of
investment in assets.
Asset
=
ratio Share capital+reserves+long term debt
It is measured as a multiple (so many times a year).

The asset turnover ratio is also the ratio of sales to (assets – current liabilities).
This is because capital employed = total assets minus liabilities excluding long-
term debt.
Example: Asset turnover ratio

The following figures relate to Company X for Year 1 .
Average capital employed (as given before) N
Profit before interest and tax = 240,000 (as given before)

N
ROCE = 240,000/1,200,000 u100=20% (as given before)
Asset turnover
ratio = N N =
Note that: ROCE =Profit/sales ratio × Asset turn over ratio (where profit is defined as
profit before interest and taxation).
Using the figures shown earlier:
= ×
employed
1,200,000 = 5,800,000 × 1,200,000
20% = 4.14% × 4.83 times
2.7 Percentage annual growth in sales

It can be useful to measure the annual growth (or decline) in sales, measured as
a percentage of sales in the previous year.
For example, if sales in the year just ended were N5,800,000 and sales in the
previous year were N5,500,000, the annual growth in sales has been (N 300,000/
N 5,500,000)×100%=5.45%.

3 WORKING CAPITAL EFFICIENCY RATIOS
Purpose of working capital efficiency ratios

Average time to collect (receivables days or days sales outstanding)
Average time for holding inventory (inventory turn over)
Average time to pay suppliers
Cash operating cycle/working capital cycle
3.1 Purpose of working capital efficiency ratios

Working capital efficiency ratios measure the efficiency with which the entity has
managed its receivables, inventory and trade payables. The ratios are usually
measured in terms of an average number of days.
The working capital ratios are a useful measure of whether the entity has too
much or too little invested in working capital.
Excessive investment in working capital is indicated by a long cash cycle (a
long working capital cycle) that appears to be getting even longer. When too
much is invested in working capital, the return on capital employed and ROSC
will be lower than they should be.
Under-investment in working capital is an indication of possible liquidity
difficulties. When working capital is low in comparison with the industry average,
this might indicate that current assets are being financed to an excessive extent
by current liabilities, particularly trade payables and a bank overdraft.
(The cash cycle, also called the operating cycle and the working capital cycle) is
explained later).
3.2 Average time to collect (receivables days or days sales outstanding)

This ratio estimates the time that it takes on average to collect the payment from
customers after the sale has been made. It could be described as the average
credit period allowed to customers or the ‘average collection period’.
Formula: Average time to collect (average collection period or average

receivables days)
Average timetocollect = u365 days

Credit sales
Trade receivables should be the average value of receivables during the year.
This is the average of the receivables at the beginning of the year and the
receivables at the end of the year.
However, the value for receivables at the end of the year is also commonly used.
Sales are usually taken as total sales for the year. However, if sales are analysed
into credit sales and cash sales, it is probably more appropriate to use the figure
for credit sales only.

Financial reporting
The average time to collect money from credit customers should not be too long.
A long average time to collect suggests inefficient collection of amounts due from
receivables.
3.3 Average time for holding inventory (inventory turn over)

This ratio is an estimate of the average time that inventory is held before it is
used or sold.
inventory days)
Inventory
Averageinventorydays = U 365 days
Costofsales
In theory, inventory should be the average value of inventory during the year.
This is the average of the inventory at the beginning of the year and the inventory
at the end of theyear.
However, the value for inventory at the end of the year is also commonly used,
particularly in examinations.
3.4 Average time to pay suppliers

The average time to pay suppliers may be calculated as follows:
Average timetopay = U 365 days

Purchases
Trade payables should be the average value of trade payables during the year.
This is the average of the trade payables at the beginning of the year and the
trade payables at the end of the year.
However, the value for trade payables at the end of the year is also commonly
used
When the cost of purchases is not available, the cost of sales should be used
instead. This figure is obtained from the profit and loss information in the
statement of comprehensive income.

Example: Working capital efficiency ratios

The following information is available for Company Y for Year 1.
1 January Year 1 31DecemberYear1

N N
Inventory 300,000 360,000
Trade receivables 400,000 470,000
Trade payables 150,000 180,000
in N N
The Working capital efficiency ratios are calculated as follows:

Efficiencyratios
Average days to collect = [435,000/3,000,000] × 365 days = 52.9 days Inventory
turn over period = [330,000/1,800,000]×365days =66.9days Average time to pay =
[165,000/1,800,000]×365days=33.5days.
Workings
= N +N = N trad
= N + N =N
trad = N + N = N
Turnover ratios (multiples)

Turnover ratios can be used as an alternative way of telling the same story as the
efficiency ratios. These show the number of times a balance in the statement of
financial position is turned over in the period.
They are multiples which provide the same insight as the efficiency ratios but in a
different way.
Credit sales
Receivables turn over =
Cost of sales Inventory

Inventory turn over =
Inventory
Purchases
Payables turn over =

Financial reporting
3.5 Cash operating cycle/working capital cycle

The cash operating cycle or working capital cycle is the average time of one
cycle of business operations:
‰ From the time that suppliers are paid for the resources theysupply
‰ To the time that cash is received from customers for the goods (or services)
that the entity makes (or provides) with those resources and then sells.
A cash cycle or operating cycle is measured as follows:
Illustration: Cash operating cycle

Days/weeks/
months
Averageinventoryholdingperiod X
Average trade receivables collection period X
X
Average period of credit taken from suppliers (X)
Operating cycle X
The working capital ratios and the length of the cash cycle should be monitored
over time. The cycle should not be allowed to become unreasonable in length,
with a risk of over-investment or under-investment in working capital.

The following figures have been extracted from a company’s accounts:

Statement of profit orloss N
Sales 1,200,000
Cost of sales:
Purchases 1,000,000

Cost of sales (1,000,000)

Trade receivables Trade 400,000
payables 166,667
Average inventory holding period:

Average inventory
Average inventory holding period- x 365 days
Annual cost of
sales
250,000
Average inventory holding period- x 365 days = 91 days
1,000,000
Average receivables collection period:

Average trade receivables
Average receivables collection period- x365days
Annual sales
400,000
Average receivables collection period- x 365 days = 122 days
1,200,000
Average payables period:

Average trade payables
Average payables period- x 365 days
Annual purchases
166,667
Averagepayablesperiod- x 365 days = 61 days
1,000,000

Days
Cash operating cycle:
Average inventory holding period 91
Average trade receivables collection period 122
Average period of credit taken from suppliers (61)
152

Financial reporting
4 LIQUIDITY RATIOS
The meaning of liquidity

Current ratio
Quick ratio or acid test ratio
Liquidity ratios and consolidated accounts
4.1 The meaning of liquidity

Liquidity means having cash or access to cash readily available to meet
obligations to make payments.
For the purpose of ratio analysis, liquidity is measured on the assumption that the
only sources of cash available are:
▪ Cash in hand or in the bank, plus
▪ Current assets that will soon be converted into cash during the normal
cycle of trade.
It is also assumed that the only immediate payment obligations faced by the
entity are its current liabilities.
There are two ratios for measuring liquidity:
▪ Current ratio
▪ Quick ratio, also called the acid test ratio.
The more suitable ratio for use depends on whether inventory is considered a
liquid asset that will soon be used or sold and converted into cash from sales.
4.2 Current ratio

The current ratio is the ratio of current assets to current liabilities.
Formula: Current ratio

Current assets
Current ratio =
Current liabilities
The amounts of current assets and current liabilities in the statement of financial
position at the end of the year may be used. It is not necessary to use average
values for the year.
It is sometimes suggested that there is an ‘ideal’ current ratio of 2.0 times (2:1).
However, this is not necessarily true and in some industries, much lower current
ratios are normal. It is important to assess the liquidity ratios by considering:
‰ Changes in the ratio overtime
‰ The liquidity ratios of other companies in the same period
‰ The industry average ratios.
Liquidity should be monitored by looking at changes in the ratio over time.

4.3 Quick ratio or acid test ratio

The quick ratio or acid test ratio is the ratio of current assets excluding inventory
to current liabilities. Inventory is excluded from current assets on the assumption
that it is not a very liquid item.
Formula: Quick ratio

Current assets excluding inventory
Quick ratio =
Current liabilities
The amounts of current assets and current liabilities in the statement of financial
position at the end of the year may be used. It is not necessary to use average
values for the year.
This ratio is a better measurement of liquidity than the current ratio when
inventory turnover times are very slow, and inventory is not a liquid asset.
It is sometimes suggested that there is an ‘ideal’ quick ratio of 1.0 times (1:1).
However, this is not necessarily true and in some industries, much lower quick
ratios are normal. As indicated earlier, it is important to assess liquidity by looking
at changes in the ratio over time, and comparisons with other companies and the
industry norm.
4.4 Liquidity ratios and consolidated accounts

Liquidity ratios are more informative when they are calculated for individual
companies. When liquidity ratios are calculated from a consolidated statement of
financial position, they are average measures for all the companies in the group.
The average liquidity ratios for the group might hide the fact that there may be
poor liquidity in some of the subsidiaries in the group.

Financial reporting
5 DEBT RATIOS
Gearing (leverage) ratios

Interest coverratio
Debt ratios are used to assess whether the total debts of the entity are within control
and are not excessive.
5.1 Gearing (leverage)ratios

Gearing (also called leverage), measures the total long-term debt of a company
as a percentage of either:
‰ The equity capital in the company: or
‰ The total capital of the company.
Formula: Debt to equity ratio

Long term debt
Debt to equity ratio = u100
Share capital+reserves
Alternatively:
Long term debt

Gearingratio =
Share capital + reserves + long term debt
It is usually appropriate to use the figures from the statement of financial position
at the end of the year. However, a gearing ratio can also be calculated from
average values for the year.
When there are preference shares, it is usual to include the preference shares
within debt capital.
A company is said to be high-geared or highly-leveraged when its debt capital
exceeds its share capital and reserves. This means that a company is high- geared
when the gearing ratio is above either 50% or 100%, depending on which method
is used to calculate the ratio.
A company is said to be low-geared when the amount of its debt capital is less
than its share capital and reserves. This means that a company is low-geared
when the gearing ratio is less than either 50% or 100%, depending on which
method is used to calculate the ratio.

A high level of gearing may indicate the following:

▪ The entity has a high level of debt, which means that it might be difficult for
the entity to borrow more when it needs to raise new capital.
▪ High gearing can indicate a risk that the entity will be unable to meet its
payment obligations to lenders, when these obligations are due for
payment.
The gearing ratio can be used to monitor changes in the amount of debt of a
company over time. It can also be used to make comparisons with the gearing
levels of other, similar companies, to judge whether the company has too much
debt, or perhaps too little, in its capital structure.
Gearing and consolidated accounts

The gearing ratio for a group of companies is difficult to interpret, because the
debt will be spread over several entities in the group.
When measuring gearing, the total capital or equity capital (the denominator in
the ratio) should include non-controlling interests (minority interests).
5.2 Interest cover ratio

Interest cover measures the ability of the company to meet its obligations to pay
interest.
Formula: Interest cover

Profit before interest and tax
Interestcover =
Interest charges in the year
Profit before interest and taxation is calculated by adding the interest charges for
the year to the figure for profit before taxation.
A low interest cover ratio suggests that the company could be at risk from too
much debt in relation to the amount of profits it is earning.
Note that what constitutes low or high gearing very much depends on the type of
company. For example:
▪ Companies with high levels of physical assets (e.g., property companies)
are able to borrow because they can offer assets as security to lenders.
▪ Companies with low levels of physical assets (e.g., advertising companies)
might be expected to have lower levels of borrowing because they cannot
offer assets as security to a lender.

Financial reporting
Example: Gearing ratios

The following information is available for Company Z for Year 6:
At 31 December Year 6
N 000
Total assets 5,800
Share capital 1,200

Reserves 2,400
3,600
Long-term liabilities (Bank loans) 1,500
5,100
Current liabilities 700
5,800
For the year to 31 December Year 6 N 000

Profit before interest and taxation 700
Interest (230)
470
Taxation (140)
Profit after taxation 330
The following ratios can be calculated to shed light on the company’s gearing in Year 6
(compared to previous years or to other companies).
Debt to equity ratio: 1,500/3,600 u100 = 41.7%
Gearing ratio: 1,500/5,100 u100 = 29.4% Interest cover:
700/230 = 3.04 times

6 INVESTOR RATIOS
Earnings per share (EPS)

Price earnings ratio (P/Eratio)
Dividend yield
Dividend cover
Investor ratios are of interest to investors in shares and bonds and their advisers.
Some of these measure stock market performance. Earnings per share (EPS) and the
price earnings ratio (P/E ratio) were described in an earlier chapter.
6.1 Earnings per share(EPS)

EPS is normally viewed as a key measure of an entity’s financial performance. It
measures the profit earned for each equity share of the entity.
Basic EPS is calculated as follows:
Formula: Basic EPS

Netprofit (or loss) attribute able to ordinary shareholders during a period
6.2 Price-earnings ratio (P/Eratio)

The price/earnings (P/E) ratio measures how expensive or cheap a share is in
relation to its annual earnings. A P/E ratio of 10, for example, means that investors
are prepared to pay a price for the share equal to 10 years of earnings (at the
level of EPS in the previous year). A high P/E ratio is usually a sign of confidence
in an entity, because it suggests that its earnings are expected to grow in future
years. A low P/E ratio usually means that an entity’s future prospects for EPS
growth are expected to be poor, so that investors do not put a high value on the
shares.
The P/E ratio is calculated as follows:
Formula: Price earnings ratio

Market value of share
P/Eratio =
Earnings per share

Financial reporting
6.3 Dividend yield

The dividend yield measures the dividend paid by an entity in relation to its price.
It is calculated as follows:
Formula: Dividend yield

Dividend per share
Dividend yield = u100
Current market price per share
This is a measure of the return that a shareholder can obtain (the dividend
received) in relation to the current value of the investment in the shares (the price
of the shares). A high dividend yield might seem attractive to investors, but in
practice companies with a high dividend yield might have a relatively low share
price.
There are two things to note:
‰ Dividend yield reflects the dividend policy of the entity, not its actual
performance. Management decides on the amount of the dividend and this
may not only depend on earnings, but on the amount that must be retained
for future investment in EPS growth.
‰ The ratio is based on the most recent dividend, but the current share price
may move up and down in response to the market’s expectations about
future dividends. This may lead to distortion in the ratio.
6.4 Dividend cover

The dividend cover ratio measures the number of times that an entity’s dividends
are ‘covered’ by profits (how many times an entity could pay the current level of
dividend from its available profits).
It is calculated as follows:
Formula: Dividend cover

Earnings per share
Dividendcover =
Dividend per share
or
Earnings
=
Dividends
A low dividend cover (for example, less than 2), suggests that dividends may be
cut if there is a fall in profits.

Example: Dividend yield and dividend cover

The following amounts relate to Entity Q.
The current market price of its equity shares is N5.50 pershare.
Profit for the most recent period was N1.4 million and equity dividends paid were
N450,000.
There are1.2million N1equity shares in issue.
1,400,000
Earnings per share= = N1.17.
1,200,000
5.50
P/E ratio = = 4.7
1.17
450,000
Dividendpershare= = 0.38
1,200,000
0.38
Dividend yield = u100% = 6.9%
5.50
1,400,000 1.17
Dividend cover = = 3.1 times or = 3.1 times
450,000 0.38

Financial reporting
7 LIMITATIONS OF INTERPRETATION TECHNIQUES
Differences in accounting policy

Other limitations in the use of financial ratios
Using historical information
Creative accounting
Using figures from the statement of financial position
Non-financial information
There are several limitations or weaknesses in the use of interpretation techniques for
analysing the financial position and financial performance of companies. Some of these
are limitations of ratio analysis (the method of interpretation most often used) and some
are limitations of financial statements and financial information.
7.1 Differences in accounting policy

One of the uses of financial ratios is to compare the financial position and
performance of one company with those of similar companies for the same
period.
Comparisons between companies might not be reliable, however, when
companies use different accounting policies, or have different judgements in
applying accounting policies or making accounting estimates. For example:
▪ Entities might have different policies about the revaluation of non-current
assets.
▪ Entities might use different methods of depreciation.
▪ Entities might use different judgements in estimating the expected
profitability on incomplete construction contracts.
▪ Entities might use different judgements in assessing whether a liability
should be treated as a provision or a contingent liability.
IAS 8 states that an entity should not change its accounting policies unless the
change is required by an accounting standard or it will result in more relevant and
reliable information. Therefore, changes should not happen often.
Where there has been a change in an accounting policy, IAS 8 also requires
comparative figures to be restated and information to be disclosed. However,
changes in accounting policies and accounting estimates can still make it difficult
to compare the financial statements of an entity over time, particularly if analysis
is based on extracts rather than the full published financial statements.

7.2 Other limitations in the use of financial ratios

There are other problems with the use of financial ratios, particularly where these
are used to compare the performance and position of different entities or of an
entity with an industry average.
▪ It is possible to calculate the same ratio in different ways. For example,
there are several variations of return on capital employed (ROCE) and
gearing. Comparisons can be misleading if different calculations are used.
▪ Even where two entities operate in the same industry, comparisons can be
misleading. Entities can operate in different markets (for example, high
volume/low margin sales and low volume/high margin sales). The size of an
entity can affect the way it operates and therefore its ratios. For example,
large entities can often negotiate more favourable terms with suppliers than
small ones.
▪ Financial statements are published infrequently. If ratios are used to study
trends and developments over time, they are only useful for trends or
changes over one year or longer, and not changes in the short term.
▪ Ratios can only indicate possible strengths or weaknesses in financial
position and financial performance. They might raise questions about
performance, but do not provide answers. They are not easy to interpret,
and changes in financial ratios over time might not be easy to explain.
It can be argued that financial position and financial performance should be
analysed using market values rather than accounting values. For example, it can
be argued that investment yield is more relevant for the assessment of financial
performance than return on capital employed.
7.3 Using historical information

Financial statements are not normally published until several months after the
year end. The financial statements are often out of date by the time that they
become available.
Historical cost accounts can also be misleading because they do not accurately
show the effects of inflation over time. The result of this is that in times of
inflation:
‰ Assets might be understated; and
‰ Profit tends to be overstated (up to date revenues are matched with costs
incurred earlier. For example inventory and depreciation).
Financial statements are often used to predict the future performance of an
entity. Where comparative figures are available for several years it may be
possible to extrapolate trends and to base forecasts on these. If comparative
figures are only available for one or two years, predictions may be unreliable.
There may be some limited information about future transactions in the notes to
the financial statements. For example, details of contingent liabilities and non-
adjusting events after the reporting period must be disclosed. However, published
financial statements present historical information and do not anticipate the effect
of significant changes to the entity after the financial statements have been
authorised for issue. These may include events beyond the control of management
(for example, the liquidation of a major customer) or events that could not possibly
have been fore seen at the time the most recent financial statements were issued.

Financial reporting
7.4 Creative accounting

Management may use various forms of creative accounting to manipulate the
view given by the financial statements while complying with all applicable
accounting standards and regulations.
Some of the techniques that can be used have been discussed in earlier
chapters. They include:
▪ Window dressing: an entity enters into a transaction just before the year
end and reverses the transaction just after the year end. For example,
goods are sold on the understanding that they will be returned immediately
after the year end; this appears to improve profits and liquidity. The only
reason for the transaction is to artificially improve the view given by the
financialstatements.
▪ ‘Off balance sheet’ finance: transactions are deliberately arranged so as
to enable an entity to keep significant assets and particularly liabilities out
of the statement of financial position (= ‘off balance sheet’). This improves
gearing and return on capital employed. Examples include sale and
repurchase agreements and some forms of leasing.
▪ Changes to accounting policies or accounting estimates: for example,
an entity can revalue assets (change from the cost model to the revaluation
model) to improve gearing or change the way in which it depreciates assets
to improve profits.
▪ Profit smoothing: manipulating reported profits by recognising (usually)
artificial assets or liabilities and releasing them to profit or loss asrequired.
▪ Aggressive earnings management: artificially improving earnings and
profits by recognising sales revenue before it has been earned.
▪ Capitalising expenses: recognising ‘assets’ which do not meet the
definition in the IASB Conceptual Framework or the recognition criteria.
Examples include: human resources, advertising expenditure and internally
generated brand names.
Most of these are now effectively prevented by accounting standards. However,
management may still attempt ‘creative accounting’, especially if the entity is
suffering falling profits or poor cash flow.
If directors’ salaries or bonuses are based on profits or on particular measures,
(such as earnings per share), they may try to manipulate that particular measure
so that it is as favourable to them as possible.

7.5 Using figures from the statement of financial position

In practice, ratio calculations are often based on figures in the year-end
statement of financial position. These may be very similar to average values for
the period, but this is not always the case.
Some businesses are seasonal and make a high proportion of their sales at a
specific time of year (for example, in the few months before a national holiday
period). Seasonal businesses often arrange their year-ends so that they fall when
inventories and receivables are at their lowest (probably just after the main period
for sales). Where this happens, ratios such as inventory turnover will be lower than
they would be if they were based on the average figure for the year. This means
that ratios may not be strictly comparable with those of other businesses or with
industry averages.
Major purchases of assets can have a significant effect on figures in the statement
of financial position and on ratios if they take place near the end of the accounting
period.
‰ The carrying value of non-current assets is unusually high, because cost
has increased, but a full year’s depreciation has not been charged.
‰ Return on capital employed and asset turnover are reduced, because
assets have increased but revenue and profits have not. New assets
should generate increased profits, but they have not yet been owned for
long enough to do so.
7.6 Non-financial information

One of the most serious limitations of traditional financial statements is that they
only reflect the financial effects of transactions. Items are not recognised unless
they can be measured reliably in money terms.
There are two problems here:
▪ Businesses and the transactions that they enter into are becoming
increasingly complex. Much information that is relevant to users cannot
be expressed easily in monetary terms or innumbers.
▪ Businesses increasingly accept that they are not only accountable to
investors and lenders, but to a much wider group of people, or
‘stakeholders’. Stakeholders can include customers, suppliers,
employees, the local community as a whole and (for some large public
entities) society as a whole. These groups are often more interested in
the non-financial effects of an entity’s activities, (for example, its effect
on the natural environment), than in its financial performance.
▪ Most large and listed entities now include a Business Review, or an
Operating and Financial Review (sometimes called Management
Discussion and Analysis) in their published financial statements. This is
a narrative report which sets out management’s analysis of the business.
Such a review is a legal requirement for many companies within the
European Union.
▪ At present entities reporting under IFRSs do not have to publish any non-
financial information of this kind. Recently the IASB issued a non-
mandatory “Practice Statement on Management Commentary”. It is up to
companies or individual legal jurisdictions to decide whether to follow this
guidance.

Financial reporting
Useful non-financial information

Useful non-financial information could include the following:
▪ a description of the business, objectives and strategies of the entity
▪ a narrative review of the performance of the business during the period
▪ a description of the main risks and uncertainties facing the entity and the
ways in which these risks are managed
▪ details of any significant factors or events that may have an impact on the
entity’s performance in future
▪ details of any significant factors or events that may have an impact on the
entity’s cash flows in future
▪ information about key relationships with other entities and transactions with
related parties, including management
▪ a description of the entity’s research and development activities (if any) and
of any material intangible assets, including internally generated in tangible
assets that have not been recognised in the balance sheet
▪ additional explanations of amounts included in the financial statements,
where appropriate (for example, where these are based on estimates)
▪ information about the entity’s policies in relation to environmental matters,
in relation to its employees and on social and community issues.

8 EARNINGS PER SHARE AS A PERFORMANCE MEASURE
Earnings per share and trends

Limitations of earnings per share
8.1 Earnings per share and trends

Investors and their advisers pay close attention to an entity’s net profit for the
period. However, profit for the period can include large and unusual items and
also the results of discontinued operations. This may make it volatile: liable to
fluctuate rapidly up and down. Users can then find it difficult to assess trends in
the profit figure or to use the current year’s profit to predict an entity’s
performance in future years.
The trend (improvement or deterioration) in an entity’s published EPS figure can
sometimes be a more reliable indicator of future performance. There are a
number of reasons for this.
‰ The standard version of both basic and diluted EPS is based on profit from
continuing operations. This means that the results of discontinued
operations (which may distort total profit) are excluded.
‰ An entity may also choose to present one or more alternative versions of
EPS. These normally exclude large or unusual items so that EPS is based
on ‘normal’ recurring earnings.
‰ EPS measures an entity’s performance from the viewpoint of investors. It
shows the amount of earnings available to each ordinary shareholder. This
means that EPS takes the effect of preference dividends (if any) into
account. It also takes share issues into account.
‰ Diluted EPS can provide an ‘early warning’ of any changes to an investor’s
potential return on their investment due to future share issues.
8.2 Limitations of earnings pershare

EPS is probably the single most important indicator of an entity’s performance. It
is a very useful measure when it is used as the starting point for a more detailed
analysis of an entity’s performance.
However, EPS can have serious limitations:
‰ Not all entities use the same accounting policies. It may not always be
possible to make meaningful comparisons between the EPS of different
entities.
‰ EPS does not take account of inflation, so that growth in EPS over time
might be misleading.
‰ EPS measures an entity’s profitability, but this is only part of an entity’s
overall performance. An entity’s cash flow can be just as important as its
profit (and more essential to its immediate survival). Changes in the value
of assets (holding gains) can also be an important part of performance for
some entities.

Financial reporting
‰ Diluted EPS is often described as an ‘early warning’ to investors that the

return on their investment may fall sometime in the future. However, diluted
EPS is based on current earnings, not forecast earnings. This means that it
may not be a reliable predictor of future EPS.
One of the main problems with EPS can be the way that it is used by investors
and others. Users often rely on EPS as the main or only measure of an entity’s
performance. Management know this and try to make EPS appear as high as
possible. They may attempt to manipulate the figure by using ‘creative
accounting’. They may also make decisions which increase EPS in the short term
but which damage the entity in the longer term.
The problem is mitigated in a number of ways.
‰ Rules in IFRS require disclosure of significant accounting policies and the
standardisation of the calculation of IFRS. This means that users have
access to information about the basis of the calculation of the EPS figure.
‰ It is difficult to imagine that a company would publish EPS information
prepared by anyone other than a qualified accountant. Users can take
comfort from the fact that members of ICAN are governed by a strict ethical
code which, if followed, would prevent the use of creative accounting
techniques. Members of other institutes are bound by ethical requirements.
‰ The problem could be further mitigated by educating users not to rely on
this single measure. Note that investment professionals would not base
advice and decisions on a single measure.

9 USING CASH FLOW INFORMATION
The statement of cash flows and the statement of profit or loss

Interpreting the statement of cashflows
9.1 The statement of cashflows and the statement of profit or loss

A cash flow statement can provide a different view of the entity’s activities from
that shown by the statement of profit or loss. An entity’s profit for a period differs
from its cash flow for a period because:
‰ the statement of profit or loss and statement of financial position are
prepared on an accruals basis; and
‰ cash flows are not affected by an entity’s accounting policies or accounting
estimates.
There are many reasons why cash flow information is useful.
‰ Cash flows are a matter of fact and are therefore difficult to manipulate.
‰ Cash flow information for the current period can often help users to predict
the amount, timing and likelihood of cash flows in future periods.
‰ Cash flow is easier to understand than profit, particularly for users with little
knowledge of business or accounting.
‰ If the statement of cash flows is prepared using the indirect method, it
shows the relationship between an entity’s profit and its cash generating
ability. It reconciles net profit before tax or operating profit to cash
generated from operations.
‰ The statement of cash flows shows all cash inflows and outflows for a
period, from all activities.
However, cash flow information has some limitations. One of the main ones is
that cash balances are measured at a point in time. Management can:
‰ deliberately arrange receipts and payments of cash, for example by
delaying the payment of suppliers until after the year-end
‰ arrange transactions so that the cash balance is affected as little as
possible, for example, by leasing an asset rather than by purchasing it
outright.
Management have a duty to safeguard an entity’s cash and to use it properly.
The practices above are legitimate ways of doing this, but it is also possible to
arrange transactions deliberately so that the entity has a much higher cash
balance than usual at a particular time. For example, an asset may be sold and
almost immediately repurchased.

Financial reporting
There are other limitations:

‰ The statement of cash flows is based on historical information and
therefore does not provide complete information for assessing future cash
flows.
‰ Cash flow is not the same as earnings. Although an entity needs cash to
survive in the short term, it must eventually be profitable or cease trading.
Neither the statement of cash flows nor the statement of profit or loss provides a
complete picture of a company’s performance. The main financial statements (the
statement of financial position, statement of profit or loss and other
comprehensive income, statement of changes in equity and statement of cash
flows) reflect different aspects of the same transactions and should be considered
together.
9.2 Interpreting the statement of cashflows

As well as preparing a statement of cash flows, you may be asked to comment
on the cash inflows and outflows of the entity and its cash position. The easiest
way to do this is to start at the beginning of the statement and work through it.
Cash generated from operations

Compare this figure to profit before tax/operating profit. How different are the two
figures? Why are they different? Look at the items in the first part of the statement,
particularly the movements in inventories, receivables and payables. If cash
generated from operations is about the same as, or higher than operating profit,
there is probably no cause for concern.
If cash generated from operations is much lower than profit, this may be a
worrying sign. If there are also large increases in inventories, receivables and
payables, possible reasons are that:
‰ The entity is expanding very rapidly and this is absorbing cash generated
fromoperations.
‰ Working capital management is poor.
Interest paid, taxation paid and dividends paid

Compare these with cash generated from operations. Remember that the entity
has to meet its liabilities for interest and tax, but it does not have to pay an equity
dividend.
Are tax, interest and dividend payments covered by cash generated from
operations? The answer should normally be yes.
Investing activities
The main items here are usually the purchase of new non-current assets (an
outflow) and the sale of non-current assets (an inflow). Has the entity invested a
significant amount of cash during the year? If so, how has the purchase been
financed? From existing cash balances, a share issue, long term borrowing or a
combination of all three?
Capital investment is usually a good sign; the new assets will generate increased
profits and cash flows in future. However, if the entity has financed the purchase
mainly or wholly from short-term sources, such as an overdraft, this is normally not
a good sign. It means that the entity may become dangerously short of cash to
meet its normal day-to-day needs.

Financing activities
Has the entity raised finance during the year? If so, was this by a share issue, or
by borrowing, or a combination of the two? The reason for raising finance is often
clear; usually it is to finance investment and/or an expansion of the business.
If borrowings have increased, will the entity have enough cash available to meet
additional interest payments in future?
Has the entity repaid borrowings during the year? When do the entity’s existing
borrowings have to be repaid? How easily will the entity be able to make
repayments?
Increase/decrease in cash and cash balances

The overall increase or decrease in cash needs to be considered in the context of
the statement of cash flows as a whole. A decrease is not necessarily a bad sign.
For example, the entity may have had surplus cash in the previous year or may
have repaid a loan.
In the same way, an increase in cash or a huge cash balance is not always a
good sign, if the cash could have been invested elsewhere to generate profit.
Does the entity have a positive cash balance or a bank overdraft? If an overdraft,
how close is it to its overdraft limit?
Does the entity have enough cash to meet both its immediate and its longer-term
needs? Consider:
‰ current liabilities (especially income tax and interest)
‰ the current level of dividends
‰ any plans for expansion of the business
‰ any other spending commitments
‰ any liability to repay borrowings with in the next twelve months.

Financial reporting
10 SPECIALISED, NOT-FOR-PROFIT AND PUBLIC SECTOR ENTITIES
Types of entity
Objectives of specialised entities
Interpretation and specialized entities
Users of the financial statements
The needs of users
Non-financial ratios
10.1 Types of entity

Most of this study text is about the financial statements of profit-making
entities, such as limited liability companies.
Other types of entity also prepare and publish financial statements. These
entities include:
‰ Not-for-profit entities: such as charities, clubs and societies. Each of
these organisations is set up for a specific purpose. For example, a
charity might be set up to campaign for the protection of the natural
environment or to help the poor.
‰ Public sector entities: these include central government bodies; local
government bodies; and other organisations that operate for the benefit
of the general public, such as state schools and hospitals. A public
sector entity is owned by the state or by the general public.
Many different types of entity could be described under these headings. These
entities are different from limited liability companies, partnerships and sole
traders in one vital respect. They do not primarily exist to make a profit.
In practice, the terms ‘specialised entity’, ‘not-for-profit entity’ and ‘public
benefit entity’ are often used inter changeably.
10.2 Objectives of specialised entities

The main objective of large commercial entities is to maximise their profits in
order to provide a return to their owners (investors) in the form of a dividend.
This may not be their only objective (for example, they may provide employment
to the local community, or aim to operate in a socially responsible way), but it is
their main objective.
The objective of owner-managed businesses (small privately owned entities)
is also to make a profit.
In contrast, the main objective of a specialised entity is to carry out the
activities for which it has been created. Again, this may not be the only
objective, because all entities need some form of income. Many large
charities, for example, carry out trading activities. However, making a profit is
not the main aim. In fact, most not-for-profit entities will aim to break even,
rather than to generate a surplus of income over expenditure.

10.3 Interpretation and specialised entities

All not-for-profit entities prepare financial statements. These may not be
structured and presented in the same way as those of a profit-making entity,
but most of the interpretation techniques described above are still relevant.
As usual, the starting point is the needs of the user.
‰ What do they need to know?
‰ What are they most interested in?
‰ What decision (if any) do they need to make?
10.4 Users of the financial statements

Several different groups of people may be interested in the financial
statements, including:
‰ members (of a club or society)
‰ donors and potential donors (to a charity)
‰ those who benefit or could benefit from the activities of the entity
‰ lenders
‰ the general public, as voters, as taxpayers or in some other capacity
‰ central government (in the case of other public sector bodies)
‰ employees and others involved in the work of the entity
‰ pressure groups.
The most important users of the financial statements are likely to be either:
providers of finance or potential providers of finance; or
persons to whom the entity’s management are accountable for the way in
which money and other resources are used.
10.5 The needs of users

Users of the financial statements of a not-for-profit entity are almost always
interested in the way that the entity manages and uses its resources.
For example:
‰ A charity may be managed by Trustees on behalf of its supporters and
those who benefit from its activities.
‰ A public sector organisation is managed by elected officials on behalf of
the general public.
Typically, users will want to know whether:
‰ the entity has enough finance to achieve its objectives;
‰ the money raised is being spent on the activities for which it was
intended;
‰ the public are receiving value for money (in the case of a public sector
entity);
‰ services are being provided economically, efficiently and effectively (in
the case of a public sector entity); and

Financial reporting
‰ the level of spending is reasonable in relation to the services provided.
10.6 Non-financial ratios

Most of the ratios covered earlier in this chapter could be relevant to a not-for-
profit entity.
However, a public sector entity may also use non-financial ratios. These
measure the efficiency with which services have been provided.
Examples include:
‰ the average time that hospital patients wait for treatment;
‰ the number of schools built in an area;
‰ serious crimes per 1,000 of the population;
‰ number of complaints by members of the public in a given period;

11 CHAPTER REVIEW
Before moving on to the next chapters check that you are able to:
Calculate and interpret return on capital employed and simila ratios
Calculate and interpret profitability ratios, working capital ratios, liquidity ratios,
debt ratios and gearing ratios
Analyse performance of a company from information provided
Explain the limitations of financial statements and interpretation

Financial reporting
Contents CHAPTER
ICAN professional code
Preparation and reporting of information
Current issues
Chapter review

Financial reporting
INTRODUCTION
Aim
principles.
Detailed syllabus
F Ethics and current developments in financial reporting
1 Discuss and apply ethical issues in financial reporting.
2 Discuss developments around the inclusion of non-financial
information in financial reporting.
3 Discuss new accounting standards in issue as may be specified from
time to time.
4
Discuss the application of block chains and related technologies
Exam context
This chapter explains the purpose of interpretation and the use of common financial ratios
and cash flow information.
It also explains the limitations inherent in the interpretation of financial statements.

„ List and explain the fundamental ethical principles to be followed by members and
student members of ICAN
„ Identify and recommend solutions to ethical issues
„ Explain major current issues in IFRS

Chapter 26: Ethics and current developments
1 ICAN PROFESSIONAL CODE
Introduction
The fundamental principles
Threats to the fundamental principles
1.1 Introduction
Ethics can be difficult to define but it is principally concerned with human
character and conduct. Ethical behaviour is more than obeying laws, rules and
regulations. It is about doing ‘the right thing’. The accountancy profession is
committed to acting ethically and in the public interest.
Professional accountants may find themselves in situations where values are in
conflict with one another due to responsibilities to employers, clients and the
public.
ICAN has a code of conduct called the Professional Code of Conduct for
Members which members and student members must follow.
Generally, a member of a profession owes certain duties to the public at large,
including those who retain or employ him; to the profession itself and to all other
members of that profession, even though such duties may at times be at variance
with his own personal interests.
This Professional Code of Conduct serves as a guide to members of the
Institute, and require strict observance as a condition for continuing membership.
Professional Code of Conduct for Members
The code provides guidance in situations where ethical issues arise.
Comment
Most people are honest and have integrity and will always try to behave in the right
way in a given set of circumstances. However, accountants might face situations
where it is not easy to see the most ethical course of action. One of the main roles
of the ICAN code is to provide guidance in these situations.
Impact on members in practice

All members and student members of ICAN are required to comply with the
professional code and it applies to both accountants in practice and in business.
This chapter explains ethical issues surrounding the preparation of financial
statements and other financial information.

Financial reporting
1.2 The fundamental principles

ICAN’s Professional code expresses its guidance in terms of five fundamental
principles. These are:
‰ integrity;
‰ objectivity;
‰ professional competence and due care;
‰ confidentiality; and
‰ professional behaviour
Integrity
Members should be straightforward and honest in all professional and business
relationships. Integrity implies not just honesty but also fair dealing and
truthfulness.
A chartered accountant should not be associated with reports, returns,
communications or other information where they believe that the information:
‰ Contains a materially false or misleading statement;
‰ Contains statements or information furnished recklessly; or
‰ Omits or obscures information required to be included where such omission
or obscurity would be misleading.
Objectivity
Members should not allow bias, conflicts of interest or undue influence of others
to override their professional or business judgements.
A chartered accountant may be exposed to situations that may impair objectivity.
It is impracticable to define and prescribe all such situations.
Relationships that bias or unduly influence the professional judgment of the
chartered accountant should be avoided.
Professional competence and due care

Practising as a chartered accountant involves a commitment to learning over
one’s entire working life.
Members have a duty to maintain their professional knowledge and skill at such a
level that a client or employer receives a competent service, based on current
developments in practice, legislation and techniques. Members should act
diligently and in accordance with applicable technical and professional standards.
Continuing professional development develops and maintains the capabilities
that enable a chartered accountant to perform competently within the
professional environments.
Confidentiality
Members must respect the confidentiality of information acquired as a result of
professional and business relationships and should not disclose such information
to third parties without authority or unless there is a legal or professional right or
duty to disclose.

Confidential information acquired as a result of professional and business

relationships should not be used for the personal advantage of members or third
parties.
Professional behaviour
Members must comply with relevant laws and regulations and should avoid any
action which discredits the profession. They should behave with courtesy and
consideration towards all with whom they come into contact in a professional
capacity.
1.3 Threats to the fundamental principles

Compliance with the fundamental principles may potentially be threatened by a
broad range of circumstances. Many threats fall into the following categories:
‰ Self-interest;
‰ Self-review;
‰ Advocacy;
‰ Familiarity; and
‰ Intimidation.
Members must identify, evaluate and respond to such threats. Unless any threat
is clearly insignificant, members must implement safeguards to eliminate the
threats or reduce them to an acceptable level so that compliance with the
fundamental principles is not compromised.
Self- interest threats

Self-interest threats may occur as a result of the financial or other interests of
members or their immediate or close family members.
Such financial interests might cause members to be reluctant to take actions that
would be against their own interests.
Examples of circumstances that may create self-interest threats include, but are
not limited to:
‰ Incentive compensation arrangements.
‰ Concern over employment security.
‰ Commercial pressure from outside the employing organisation.
Example:
Bako is member of ICAN working as a unit accountant.
He is a member of a bonus scheme under which, staff receive a bonus of 10%of
their annual salary if profit for the year exceeds at rigger level.
Bako has been reviewing working papers prepared to support this year’s financial
statements. He has found a logic error in a spreadsheet used as a measurement
tool for provisions.
Correction of this error would lead to an increase in provisions. This would
decrease profit below the trigger level for the bonus.
Analysis:
Bako faces a self-interest threat which might distort his objectivity.

Financial reporting
Self-review threats
Self-review threats occur when a previous judgement needs to be re-evaluated
by members responsible for that judgement. For example, where a member has
been involved in maintaining the accounting records of a client he may be
unwilling to find fault with the financial statements derived from those records.
Again, this would threaten the fundamental principle of objectivity.
Circumstances that may create self-review threats include, but are not limited to,
business decisions or data being subject to review and justification by the same
chartered accountant in business responsible for making those decisions or
preparing that data.
Advocacy threats
A chartered accountant in business may often need to promote the organisations
position by providing financial information. As long as information provided is
neither false nor misleading such actions would not create an advocacy threat.
Familiarity threats
Familiarity threats occur when, because of a close relationship, members
become too sympathetic to the interests of others. Examples of circumstances
that may create familiarity threats include:
‰ A chartered accountant in business in a position to influence financial or
non-financial reporting or business decisions having an immediate or close
family member who is in a position to benefit from that influence.
‰ Long association with business contacts influencing business decisions.
‰ Acceptance of a gift or preferential treatment, unless the value is clearly
insignificant.
Intimidation threats
Intimidation threats occur when a member’s conduct is influenced by fear or
threats (for example, when he encounters an aggressive and dominating
individual at a client or at his employer).
Examples of circumstances that may create intimidation threats include:
‰ Threat of dismissal or replacement over a disagreement about the
application of an accounting principle or the way in which financial
information is to be reported.
‰ A dominant personality attempting to influence decisions of the chartered
accountant.

2 PREPARATION AND REPORTING OF INFORMATION
Members in business
Potential conflicts
2.1 Members in business

Accountants in business are often responsible for the preparation of accounting
information.
Accountants in business need to ensure that they do not prepare financial
information in a way that is misleading or that does not show a true and fair view
of the entity’s operations.
Chartered accountants in business are often involved in the preparation and
reporting of information that may either be made public or used by others inside
or outside the employing organisation. Such information may include financial or
management information, for example:
‰ forecasts and budgets;
‰ financial statements;
‰ management discussion and analysis; and
‰ the management letter of representation provided to the auditors as part of
an audit of financial statements.
Information must be prepared and presented fairly, honestly and in accordance
with relevant professional standards. In particular financial statements must be
prepared and presented in accordance with the applicable financial reporting
standards.
A chartered accountant in business must maintain information for which he is
responsible in a manner that:
‰ describes clearly the true nature of business transactions, assets or
liabilities;
‰ classifies and records information in a timely and proper manner; and
‰ represents the facts accurately and completely in all materialrespects.
Accountants who are responsible for the preparation of financial information must
ensure that the information they prepare is technically correct, reports the
substance of the transaction and is adequately disclosed.
There is a danger of influence from senior managers to present figures that inflate
profit or assets or understate liabilities. This puts the accountant in a difficult
position. On one hand, they wish to prepare proper information and on the other
hand, there is a possibility they might lose their job if they do not comply with their
managers wishes.
In this case, ethics starts with the individual preparing the information. They have
a difficult decision to make; whether to keep quiet or take the matter further. If they
keep quiet, they will certainly be aware that they are not complying with the ethics
of the accounting body they belong to. If they speak out, they may be bullied at
work into changing the information or sacked.

Financial reporting
Threats to compliance with the fundamental principles, for example self-interest or

intimidation threats to objectivity or professional competence and due care, may
be created where a chartered accountant in business may be pressured (either
externally or by the possibility of personal gain) to become associated with
misleading information or to become associated with misleading information
through the actions of others.
The significance of such threats will depend on factors such as the source of the
pressure and the degree to which the information is, or may be, misleading.
The significance of the threats should be evaluated and unless they are clearly
insignificant, safeguards should be considered and applied as necessary to
eliminate them or reduce them to an acceptable level. Such safeguards may
include consultation with superiors within the employing organization, for example,
the audit committee or other body responsible for governance, or with a relevant
professional body.
Where it is not possible to reduce the threat to an acceptable level, a chartered
accountant should refuse to remain associated with information they consider is
or may be misleading.
If the chartered accountant is aware that the issuance of misleading information
is either significant or persistent, he should consider informing appropriate
authorities in line with the guidance in this code. The chartered accountant in
business may also wish to seek legal advice or resign.
2.2 Potential conflicts

There may be times when the responsibilities of a chartered accountant to an
employing organisation come into conflict with their professional obligations to
comply with the fundamental principles in the Code. Where compliance with the
fundamental principles is threatened, a chartered accountant in business must
consider a response to the circumstances.
Responsibilities to an employer may put a chartered accountant under pressure to
act or behave in ways that could directly or indirectly threaten compliance with the
fundamental principles. Such pressure may be explicit or implicit; it may come from
a supervisor, manager, director or another individual within the employing
organisation.
A chartered accountant in business may face pressure to:
‰ Act contrary to law or regulation.
‰ Act contrary to technical or professional standards.
‰ Lie to, or otherwise intentionally mislead (including misleading by remaining
silent) others, in particular:
x The auditors of the employing organisation; or
x Regulators.

‰ Issue, or otherwise be associated with, a financial or non-financial report

that materially misrepresents the facts, including statements in connection
with, for example:
x The financial statements;
x Tax compliance;
x Legal compliance; or
x Reports required by securities regulators.
The significance of threats must be evaluated and unless they are clearly
insignificant, safeguards should be considered and applied to eliminate them or
reduce them to an acceptable level.
Such safeguards may include:
‰ Obtaining advice where appropriate from within the employing organisation,
or an independent professional advisor or a relevant professional body.
‰ The existence of a formal dispute resolution process within the employing
organisation.
‰ Seeking legal advice.
Example: Potential conflicts

Bako is member of ICAN and works as a unit accountant.
He is a member of a bonus scheme under which, staff receive a bonus of 10%of
their annual salary if profit for the year exceeds at rigger level.
Bako has been reviewing working papers prepared to support this year’s financial
statements. He has found a logic error in a spread sheet used as a measurement
tool for provisions.
Correction of this error would lead to an increase in provisions. This would
decrease profit below the trigger level for the bonus.
Analysis:
Bako faces a self-interest threat which might distort his objectivity.
Bako has a professional responsibility to ensure that financial information is
prepared and presented fairly, honestly and in accordance with relevant
professional standards. He has further obligations to ensure that financial
information is prepared in accordance with applicable accounting standards and
that records maintained represent the facts accurately and completely in all
material respects.
Bako must make the necessary adjustment even though it would lead to a loss to
himself.

Financial reporting
Example: Potential conflicts

Edosio is a chartered accountant who works in a team that reports to Ganiru, the
finance director of Calabar Holdings.
Ganiru is also a chartered accountant. He has a domineering personality.
Calabar Holdings revalues commercial properties as allowed by IAS 16. Valuation
information received last year showed that the fair value of the property portfolio
was 2% less than the carrying amount of the properties (with no single property
being more than 4% different). A down ward revaluation was not recognized on
the grounds that the carrying amount was not materially different from the fair
value.
This year’s valuation shows a continued decline in the fair value of the property
portfolio. It is now 5% less than the carrying amount of the properties with some
properties now being 15% below the carrying amount.
Edosio submitted workings to Ganiru in which he had recognised the downward
revaluations in accordance with IAS 16.
Ganiru has sent him an email in response in which he wrote “Stop bothering me
with this rubbish. There is no need to write the properties down. The fair value of
the portfolio is only 5% different from its carrying amount. Restate the numbers
immediately”.
Analysis
Edosio faces an intimidation threat which might distort his objectivity.
The current accounting treatment might be incorrect. The value of the properties
as a group is irrelevant in applying IAS16’s revalution model. IAS16 allows the
use of a revalution model but requires that the carrying amount of a property
should not be materially different from its fair value. This applies to individual
properties not the whole class taken together.
(It could be that Ganiru is correct because there is insufficient information to judge
materiality in this circumstance. However, a 15% discrepancy does sound
significant).
Edosio has a professional responsibility to ensure that financial information is
prepared and presented fairly, honestly and in accordance with relevant
professional standards. He has further obligations to ensure that financial
information is prepared in accordance with applicable accounting standards and
that records maintained represent the facts accurately and completely in all
material respects.

Example continued
Possible course of action
Edosio should arrange a meeting with Ganiru to try to explain Ganiru’s
misapplication of the IAS 16 guidance and to try to persuade Gani ruth at a
change might be necessary.
Ganiru should be reminded that he too is bound by the same guidance that applies
to Edosio. Indeed, he has a greater responsibility as the more senior person to
show leadership in this area.
Edosio cannot be party to the preparation and presentation of knowingly
misleading information. He should explain that he cannot remain associated with
information that is misleading. If Gani rurefuses to allow the necessary changes
to the information Edosio should report the matter to the audit committee or the
other directors.
As a last resort if the company refuses to change the information Edosio should
resign from his post.
Edosio may need to consider informing the appropriate authorities in line with the
ICAN guidance on confidentiality.

Financial reporting
3 CURRENT ISSUES
Introduction
Discussion paper: Disclosure Initiative — Principles of Disclosure
Principles of effective communication
Principles on where to disclose information
Principles to address specific disclosure concerns expressed byusers
Principles for improving disclosure objectives and requirements
Application of Block Chain and related technologies in financial reporting
3.1 Introduction
“Better communication in financial reporting” is a central theme of the IASB
agenda and will be for the next few years. Work in this area includes the
following:
‰ Disclosure Initiative projects (aims to improve disclosures in the notes to
the financial statements);
‰ Primary Financial Statements project (aims to make improvements to
structure and content with a focus on financial performance); and
‰ the IFRS Taxonomy (aims to allow structured electronic reporting of IFRS
financial information).
Background to the Disclosure Initiative

The IASB launched the Disclosure Initiative in 2013 with the aim of improving the
effectiveness of disclosures in financial statements.
Disclosure Initiative projects
Amendments to IAS1 to remove barriers Completed (reflected in Chapter 4)
to the exercise of judgement.
Amendments to IAS7 to improve Completed (reflected in Chapter 22)
disclosures about liabilities from
financing activities
Materiality implementation projects:
Materiality Practice Statement project Practice Statement
published (covered in
Chapter 3).
The Definition of “material”
ED – not covered
Research projects:
Principles of Disclosure project Discussion Paper (covered below)
The Standards-level Review of Disclosures Research phase – DP will be
project released in the future

3.2 Discussion paper: Disclosure Initiative — Principles of Disclosure
The need for principles of disclosure

The disclosure problem arises because entities have difficulty judging what
information to disclose in financial statements and how best to disclose it.
An entity might apply a disclosure requirement mechanically without considering
why it is useful to the users of financial statements. A lack of guidance in IFRS
coupled with lists of prescriptive disclosure requirements can discourage entities
from using their own judgement.
A set of disclosure principles could encourage preparers to apply better
judgement in order to allow them to communicate information more effectively to
users of the financial statements.
The discussion paper has the following content:
‰ Principles of effective communication
‰ Principles on where to disclose information
‰ Principles to address specific disclosure concerns expressed by users
‰ Principles for improving disclosure objectives and requirements
3.3 Principles of effective communication

Information in financial statements should be
‰ entity specific;
‰ clear and simple;
‰ organised to highlight important matters;
‰ linked to related information;
‰ free from unnecessary duplication;
‰ comparable;
‰ in an appropriate format.
There may be trade-offs between some of these principles to maximise the
usefulness of information for users of the financial statements. For example,
making information entity specific might mean it is relevant and easier to
understand, but could reduce comparability between entities and between
accounting periods.

Financial reporting
3.4 Principles on where to disclose information
Roles of primary financial statements and notes

Sometimes an entity can have difficulty in deciding what information to present in
the primary financial statements and what information to disclose in the notes.
Evidence suggests that users of financial statements pay more attention to the
primary financial statements than to the notes. This implies that the role of the
primary financial statements differs from the role of the notes in meeting the
objective of financial statements.
The DP identifies what constitutes the primary financial statements and considers
their role and the implications of that role and explores the role and the content of
the notes with a view to helping entities decide where to include information within
the financial statements.
Location of information
Information necessary to comply with IFRS can be placed outside financial
statements but within the annual report, provided the following are met
‰ annual report more understandable;
‰ financial statements understandable; and
‰ information faithfully represented, clearly identified andcross-referenced.
Information labelled as ‘non-IFRS’ can be placed inside the financial statements if

it is:
‰ listed, together with a statement of compliance with IFRS;
‰ identified as not in accordance with IFRS;
‰ identified as unaudited (if applicable); and
‰ accompanied by explanation of why it is useful.
3.5 Principles to address specific disclosure concerns expressed by users
Use of performance measures

The term ‘performance measure’ refers to any summary financial measure of
financial performance, financial position or cash flows.
An entity might present a performance measure that is not described in IFRS
(e.g., many entities publish EBITDA). Such a performance measure is
sometimes referred to as non-IFRS or a non-GAAP performance measure.
The DP suggests that performance measures should be
‰ clearly labelled with an explanation of the irrelevance;
‰ neutral;
‰ measured and presented consistently;
‰ no more prominent than IFRS information; and
‰ reconciled to IFRS measures.
The DP is also seeking feedback on presentation of unusual or infrequently
occurring items and the use of EBIT and EBITDA ratios.

Disclosure of accounting policies

Entities sometimes provide irrelevant information in accounting policy disclosures
or depict the information in a confusing way.
The DP outlines three categories of accounting policies as follows:
Category 1—always necessary to understand the financial statements
The accounting policy relates to material items, transactions or eventsand:
‰ is selected from alternatives in IFRS;
‰ reflects a change from a previous period;
‰ is developed by the entity in the absence of specific requirements; and/or
‰ requires use of significant judgements or assumptions.
Category 2—not in Category 1 but relates to material items, transactions and
events so is necessary to understand the financial statements
Category 3—not in Categories 1 and 2 but is used in preparing the financial
statements (all other accounting policies used).
The DP and suggests that only accounting policies necessary to understand
financial statements need be disclosed. However, an entity would not be
prohibited from disclosing Category 3 accounting policies provided that relevant
information is not obscured.
3.6 Principles for improving disclosure objectives and requirements

Feedback suggests that the absence of clear disclosure objectives in IFRS, coupled
with lists of prescriptive disclosure requirements, may be contributing to the disclosure
problem.
The lack of clear disclosure objectives can make it difficult for entities to:
‰ understand the purpose of some disclosure requirements; and
‰ apply judgement in deciding what information to disclose to meet the objective of
The DP discusses whether a central set of disclosure objectives (centralised
disclosure objectives) should be developed to inform the development of disclosure
requirements.
4.0 Application of technologies in financial reporting
4.1 Introduction
There are so many areas of financial reporting that could be enhanced by the use of
technology. They include:
• Data collation: The starting point of the financial reporting process is identification
and collection of data from multiple sources within and outside the organisation. Data
identification and collation can actually be automated through the integration of the
entity’s accounting software with the various data sources. It is equally possible to
convert the unstructured and ‘dirty’ data into a format and structure ready for entry into
the accounting system with the help of some advanced technology tools.
• Data recording: Once data is collated from various sources, the next course of action
is to enter (record) the data into the accounting system. Technology tool such as optical
character recognition (OCR) has made it possible for organisations to capture and
record data seamlessly with little or no human intervention. The data in source
documents (customer orders; invoices and delivery notes) are captured through
scanners or mobile device cameras and posted into the appropriate ledgers within the
accounting system.
• Report preparation: A well-designed and automated accounting system will be able

to aggregate all relevant information from individual ledger accounts to the general
ledger which forms the basis of preparing the trial balance and ultimately, the financial
statements and other products of financial reporting. Modern technology can enhance
this process efficiency by replacing mechanistic human processing of underlying
transactions and transforming the various data into proper accounting and
management information, which ultimately feeds into a company’s annual reports.
• Report distribution: Traditionally, annual reports of companies are published several

months after the financial year end and sent to shareholders and other stakeholders
through the postal or courier services. In recent times, many organisations through the
adoption of relevant technology tools have started hosting the annual reports on their
websites or put them on CDs and send to the stakeholders. Also, there are instances
where the soft copies of the annual reports are sent to each stakeholder’s email
address for downloading. In highly regulated sectors, such as banking industry, the
regulators could provide a web portal where each operator is required to submit the
annual reports and other returns electronically.
• Report consumption: Once the various stakeholders and investors receive the
annual reports of an entity, they attempt to analyse and make useful meaning from
them. Most institutional investors are already using technology to enhance
effectiveness of investment analysis by extracting meaning and value, not only from
company reporting, but also from various sources of alternative data. Data analytic
solutions can be used to perform detailed analysis of any company’s information for a
deeper insight that would aid decision making of investors.
4.2 Cloud computing technology: There are quite a good number of accounting software
that are hosted in the cloud. Like many other enterprises, accounting businesses must
leverage on cloud computing and switch to cloud-based accounting to stay relevant and
competitive now and in the future. Popular accounting solutions, such as QuickBooks;
Sage; SAP; etc are all available in the cloud.
When an accountant subscribes to a cloud-based solution, it relieves him of the

need to invest in physical onsite computer servers and incurring the costs
associated with its maintenance and support.
Cloud-based accounting solutions afford the accountant the opportunity to work
remotely from practically any device with internet connection and serve clients from
any location, at any time. It further helps accounting firms to facilitate collaborations
among themselves and clients.
Moreover, business entities that subscribe to cloud-based accounting can easily
upscale and downscale their resource needs depending on the requirements at any
point in time, without making huge investments.
(a) Artificial intelligence and robotics: Artificial intelligence (AI) is widely used,
though it is not taken note of. Every time a search is made using Apple Siri, search
Google or ask Amazon’s Alexa a question, a form of artificial intelligence is in use.
Many banks in Nigeria have equally deployed AI as part of their internet banking
platforms. The technology has also radically altered processes like buying an airline
ticket and making a hotel reservation.
Major accounting firms are using artificial intelligence to sort through contracts and
deeds during audits. The computer does a risk assessment and flags potential
problems.
Traditionally, accountants put a lot of efforts to collate, analyse and report historical
financial data in order to serve their clients. Generally, accountants facilitate
decision making by computing various financial ratios and generating elaborate
reports. Artificial Intelligence (AI) and Robotics make it easier for accountants to
simplify and accelerate various data-related tasks. Robotic Process Automation
(RPA) software have been demonstrated to be effective in handling routine and
monotonous aspects of the accountants’ job.
AI is capable of making accountants more productive as its algorithms allow

machines to take over time-consuming, repetitive, and redundant tasks. Rather than
just crunch numbers, accountants will be able to spend more time delivering on
higher value aspects, such as business strategy implementation and financial
advisory. Machines can help reduce costs and errors by streamlining operations.
Much of the standard data-entry that are common-place in accounting could be
performed by machines. Machines could manage invoices and low-level
bookkeeping tasks. The machine would reduce the chance that numbers are
entered incorrectly, which can cause major problems to the entire accounting
operation.
For instance, the optical character recognition (OCR) technology enables practising
firms to automate and accelerate manual entries by converting textual data to digital
files using scanners and mobile device cameras.
Apart from automating the repetitive and mundane tasks, AI would enable
accountants track changes in business finances and create comprehensive reports
by extracting financial information from various sources.
(b) Blockchain technology: Block chain technology became popular globally through
the advancements in digital currency transactions such as Bitcoin. Many businesses
now leverage on the blockchain technology to record their financial and non-
financial transactions in an open, secured and decentralised ledger.
In addition to keeping the financial transactions transparent and auditable,
blockchain further makes the transaction records accessible to authorised users at
any time and any location.
Blockchain enables quick funds transfer, recording of financial transactions
accurately, recording smart contracts, protecting and transferring ownership of
assets, verifying people's identities and credentials, and much more. Once
blockchain is widely adopted, and challenges around industry regulation are
overcome, it will benefit businesses by reducing costs, increasing traceability, and
enhancing security.
Blockchain allows for the encryption of data through blocks, which track the time
and date of a transaction. The technology could be used to make audit process
more efficient, because it would keep an accurate record of when a transaction
occurred and who authorised it. Blockchain would limit the chances of an electronic
record being altered.
Blockchain technology can then be combined with Artificial Intelligence to

investigate the integrity of transactions. The computer will do a lot of the work,
leaving the auditor to conduct the final analysis. Under this scenario, auditors will
spend most of their time designing, reviewing, and verifying how information flows
between systems. Rather than audits being conducted on a periodic basis,

blockchain and AI create the possibility of a continuous audit. The machine is always
working, and a person would be notified when a potential problem is spotted.
(c) Data analytics technology: Data has become the new cash, as it is extremely
crucial to make useful business financial decisions. Today, data is not just numbers
and spreadsheets that accountants have been familiar with for years; it also includes
unstructured data that can be analysed through automated solutions.
Data analytic software can allow for real-time status monitoring of financial matters.
Data is the fuel that powers other technology trends that are transforming finance
and accounting. In the financial realm, data produces valuable insights, drives
results and creates better experiences for clients. Since everything leaves a digital
footprint, the unprecedented digitalisation of our world is creating opportunities to
glean new insights from data that was not possible before.
These insights help accountants to improve internal operations and build valuable
insights for their organisation or clients. Through Data analytics software,
accounting firms could offer more valuable advisory to their clients.
Examples of top data analytics software include:

• MySQL Workbench;
• Datapine;
• R-Studio;
• SAS Forecasting for Desktops;
• Erwin Data Modeler;
• Talend;
• Apache Spark; and
• Rapid Miner.
REFERENCES
Accessible Accounting (2021). https://accessible accounting.co.uk/cloud-

accounting-systems-are-revolutionary-part-3/
Accounting Today. (2021). https://www.accounting

today.com/tag/technology
Alloy Silvertein Accountants and Advisors (2018).

https://alloysilverstein.com/cloud-accounting-vs-desktop-accounting-comparison-
infographic/
Ezeribe, C. (2018). Audit & Assurance Essentials. Abuja: Topnotch Learning

Publication.
ISACA, (2019). Transforming IT Audit, accessed 31 May 2019.

https://transformingaudit.isaca.org/

Financial reporting
4 CHAPTER REVIEW
List and explain the fundamental ethical principles to be followed by members
and student members of ICAN
Identify and recommend solutions to ethica lissues
Explain major current issues in IFRS

Skills level
a b
Accounting Bargain purchases 542
concepts 46 Basic EPS 652
estimates 103 Bid /Offer prices 415
for Bonus issues of shares 658
depreciation 183
revaluation 193
standards
Accrualsbasis
3
47
c
Acidtest ratio 697
Acquired intangible assets 519 Capital maintenance 52
Actuarial method 324 Carrying amount 182
Adjusting events after the reporting Cash
Period 582 flow/s
Adoption of IFRS in Nigeria 13 from
Analysis of expenses 74 financing activities 598
Assets 40, 69 investing activities 597
AVCO 169 operating activities 596
Average time information 711
for holding inventory 692 statements 593
To generated from operations 596
Collect 691 operating cycle 694
pay suppliers 692 Cash-generating units 284
Changes in accounting
estimates 104
policies 99
Classification and measurement of
financialassets 433

Financial reporting
financialliabilities 443 Decommissioning liabilities and

Commencement date ofa lease 312 similarprovisions 354
Commonreporting date 480 Defaultsandbreaches 468
Companies and Allied Matters Act Depreciation 182
(CAMA)2004 16 by number ofunitsproduced 188
Companylaw 3 of are-valued asset 199
Comparability 38 Derecognition 44
Components of offinancialinstruments 425
equity 77 Developmentcosts 259
taxexpense 394 DilutedEPS 664
Compoundinstruments 460 optionsandwarrants 668
Conceptual framework for financial Directmethod 599, 600, 601, 620
reporting(The) 29 Directorate ofAccountingStandards 12
Consistencyof presentation 46 Disclosure Initiative 730
Consolidated Principles of Disclosure 731
financialstatements 479 Discontinued operations 302
incomestatement 549 Disposal of property, plant and
statement of profit or loss and equipment 204
othercomprehensiveincome 549 Dividend/s 583
Constructiveobligation 338 cover 702
Contingent paid 609
asset 359 yield 702
liability 358
Control 476
Conversion costs
Convertible
159
e
bonds 665
preferenceshares 665 Earnings pershare(EPS) 649,701
Correction of priorperiod errors 106 andtrends 674,709
Cost 158 Elements of
constraint onuseful information 39 cost 178
formulasfor inventory 164 financialstatements 40
model forinvestmentproperty 241 End-of-year adjustmentsforinventory 151
Cost/salesratios 688 Enhancingqualitativecharacteristics 38
Creative accounting 30, 706 EPS
Credit risk 469 convertible preference shares
Current andconvertiblebonds 665
assets 68 Equity 70
liabilities 69 instrument 459
ratio 696 method 568
value 50 shares 465
Errors 106
Estimates 103
d Ethics and Conduct
Events after the reporting period
722
IAS 10 581
Dayssales outstanding 691 Exchange transactions 178
Debtratios 698 Expenses 42

Index
f i
Fair IAS 1: Presentation of Financial
presentation 56 Statements 62
and compliancewithIFRSs 63 IAS 8: Accounting policies, changes
value 51 in accounting estimates and
errors 57,97
hierarchy 415
IAS 10: Events after the reporting
model forinvestmentproperty 240
period 581
Faithful representation 38
IAS 16: Property, Plant and
FIFO 164 Equipment 192
Financial 428
IAS 20: Accounting for government
capital maintenance 52 grants and disclosure of
instruments 423 government assistance 231
liability 459 IAS 23: Borrowing costs 227
Reporting Council of Nigeria 11 IAS 28: Investments in associates
statements and the reporting and joint ventures 567
entity 35 IAS 32: Financial instruments:
Financing activities 639 Presentation 423, 459
First-in, first-out method (FIFO) 165 IAS 36: Impairment of assets 277
Format of published accounts 62 IAS 38: Intangible assets 251
Fundamental principles 722 IAS33
Future operating losses 352 and diluted EPS 664
Earnings per share 649
IASB 6
g Conceptual Framework
Framework
32
29
IFRS 3: Business combinations 499
GAAP 29 IFRS 5: Non-current assets held for
Gain or losson disposal 202 sale anddiscontinuedoperations 302
Gearingratios 698 IFRS 7: Financialinstruments:
General purposefinancialstatements 62 Disclosure 423, 467
Goingconcernassumption 36,583 IFRS 11: Joint arrangements 565
Government grant 231 IFRS 15: The five step model 115
Grants related to IFRS Taxonomy 730
assets 233 Impairment
income 232 loss on a disposal group 299
Gross profit ratio 689 of assets 277
of financial assets 448
of goodwill 552, 559
h Inception
and commencement 312
date of the lease 312
High-geared 698 Income 42
Historicalcost 50 Indirectmethod 599
Holdingcompany 476 adjustments forworkingcapital 610
Initial direct costs ofalease 317

Financial reporting
In-process research and madein advance 327

development 263 term 313
Intangible assets Legalobligation 338
acquired in a business Lessee’s incrementalborrowingrate 318
combination 261 Leverage 698
definition 252 Liabilities 41,69
disclosure requirements 265 Liquidity
granted by government 256 ratios 696
internally generated 257 risk 470
recognition 254 Listingrules 3
separate acquisition 255 Low-geared 698
Integrity 722
Interest
and dividends received
cover ratio
609
699
m
payments 608
rate implicit in the lease 315 Marketrisk 470
taxation and dividends 608 Material
Internally-generatedintangibles 257 items 74
International non-adjustingevents 582
Accounting Standards Board Materialityand aggregation 46
(IASB) 6 Measurementof inventory 158
Financial Reporting Standards Mostadvantageous market 410
Interpretations Committee
(IFRSIC) 6
GAAP
Inventory turnover
56
692 n
Investing activities 627
Investment property 239
Negativegoodwill 542
Investor ratios 701
Net
Issued shares 465
cash from operating activities 596
profit ratio 689
j
realisable value (NRV) 51, 158
Nigerian Accounting Standards Board
(NASB) 11
Non-adjusting events after the
Joint reportingperiod 582
arrangements 565 Non-financial
operation 566 information 707
venture 566 ratios 716
Not-for-profit entities 714
l
o
Lease 311
liability 322 Objectivity 722
payments 314 Off balancesheet finance 706

Index
Offsetting 46, 463

Onerous contracts
Operational cash flows
351
602, 620
r
Ordinary share 650
Other comprehensive income 72 Realisable value 50
Over-estimate or under-estimate of Receivables days 691
tax 370 Recognition 44
criteria 44
forintangibleassets 254
p offinancialinstruments
Recoverableamount
424
279
Reducingbalancemethod 187
Parent entity 476 Regulation 3
Part-exchange of an old asset 207 Relatedparty 585
Percentage annual growth in sales 690 transactions 586
Perpetual inventory method 152 Relevance 38
Physical capital maintenance 53 Reporting entity 36
Portfolio application 330 Research and development 258
Potential ordinary share/s 651 Restructuring 352
that arenotdilutive 670 Retrospective
Pre- and post-acquisition profits 551 adjustments 78
Pre-acquisition profits 484 application 100
Preparing financial statements 84 Return on
Present value 50 capitalemployed 685
Presentation shareholdercapital 687
taxation 392 Revaluation
Price/earningsratio 649 model 201
(P/Eratio) 701 of property, plantandequipment 192
Principal market 410 Right-of-useasset 319
Professional code 721 Rights issuesofshares 661
Profit/sales ratio 688
Proposed dividends 583
Prospective application
Public sector entities
104
714
s
Purchase cost 158
Self-reviewthreats 724
Settlementvalue 50
q Share
options 668
warrants 668
Qualifyingasset 227 SOCIE 77
Qualitative Specialisedentities 714
characteristics of useful financial Split accounting for compound
information 37 instruments 460
disclosures 469 Standards AdvisoryCouncil(SAC) 7
Quantitativedisclosures 469 Statement/s of
Quickratio 697 cashflows 593
changesinequity 77

Financial reporting
financialposition 71
profit or loss and other
comprehensive 73
u
Straight-linemethod 186
Subsequentexpenditure 180 Understandability 39
Subsidiary 476 Uniformaccountingpolicies 480
Users and theirinformationneeds 32
t v
Tax
base 369 Valuein use 279

computation 367 Verifiability 39
reconciliation 395
Taxationofprofits 367
Timeliness
Totalcomprehensiveincome
39
72
w
Transaction/s
Weighted averagecost(AVCO) 164
costs of issuing new equity
shares 465 method 169
inownequity 463 Windowdressing 706
Transitionalprovisions 99 Working capital
Treasuryshares 463 adjustments 610
True andfair view 56 cycle 694
efficiency ratios 691

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Financial Reporting

The Institute of Chartered

© Emile Woolf International, April 2019

© Emile Woolf International ii The Institute of Chartered Accountants of Nigeria

© Emile Woolf International iii The Institute of Chartered Accountants of Nigeria

© Emile Woolf International iv The Institute of Chartered Accountants of Nigeria

Linkage with other subjects

Taxation Financial Accounting Business

© Emile Woolf International v The Institute of Chartered Accountants of Nigeria

Linkage of the main competencies

Account for Understand

© Emile Woolf International vi The Institute of Chartered Accountants of Nigeria

Detailed syllabus Chapt

c Identify and discuss relevant provisions of Companies and Allied

d Explain the standard setting process of International Accounting

e Discuss the process for revision of standards.

g Explain the peculiar nature and relevant frameworks of specialized,

© Emile Woolf International vii The Institute of Chartered Accountants of Nigeria

Detailed syllabus Chapter

© Emile Woolf International viii The Institute of Chartered Accountants of Nigeria

Detailed syllabus Chapter

© Emile Woolf International ix The Institute of Chartered Accountants of Nigeria

Detailed syllabus Chapter

© Emile Woolf International x The Institute of Chartered Accountants of Nigeria

Detailed syllabus Chapter

© Emile Woolf International xi The Institute of Chartered Accountants of Nigeria

Applicable accounting standards Chapter

IAS 28: Investments in associates and joint ventures 21

© Emile Woolf International xii The Institute of Chartered Accountants of Nigeria

© Emile Woolf International 1 The Institute of Chartered Accountants of Nigeria

b Identify and discuss laws, regulations, accounting standards and otherrequirements

d Explain the standard setting process of International Accounting Standards Board

e Discuss the process for revision of standards.

f Discuss the process of adoption of IFRSs and application of local standards.

By the end of this chapter, you will be able to:

Outline the roadmap for conversion to IFRS in Nigeria

© Emile Woolf International 2 The Institute of Chartered Accountants of Nigeria

1 THE REGULATORY FRAMEWORK

The need for regulation

1.1 The need for regulation

1.2 Sources of regulation

example, in Nigeria, the Central Bank prudential guidelines override impairment

1.3 Principles and rules

2 THE IFRS FOUNDATION AND THE IASB

Illustration: Standard setting structure

The IFRS Foundation

The constitution of the Foundation includes a requirement that, in order to achieve a

The International Accounting Standards Board (IASB)

The IFRS Interpretations Committee (IFRSIC)

The IFRS Advisory Council (IFRSAC)

2.3 IFRSs andIASs

Previously, standards had been published as International Accounting Standards

Thus IFRS is made up as follows:

Published bythe IASC Published by the IASB

IAS12 – Income Taxes Yes Yes (inpart)

IAS 19 – Employee Benefits Yes No

© Emile Woolf International 9 The Institute of Chartered Accountants of Nigeria

2.4 Developing a newstandard

The development of a new or revised accounting standard involves widespread