CPA Australia-Financial Reporting-Study Manual - 4th Edition (2018)

CPA PROGRAM
FINANCIAL
REPORTING
4TH EDITION
CPA PROGRAM
FINANCIAL
REPORTING
4TH EDITION
Published by Deakin University, Geelong, Victoria 3217, on behalf of CPA Australia Ltd, ABN 64 008 392 452
First edition published January 2010, updated July 2010, updated January 2011, reprinted July 2011,
updated January 2012, reprinted July 2012, updated January 2013, revised edition January 2013,
reprinted July 2013, updated January 2014, revised edition January 2015, updated July 2015,
updated January 2016
Third edition published November 2016
Fourth edition published January 2018
© 2010–2018 CPA Australia Ltd (ABN 64 008 392 452). All rights reserved. This material is owned or
licensed by CPA Australia and is protected under Australian and international law. Except for personal and
educational use in the CPA Program, this material may not be reproduced or used in any other manner
whatsoever without the express written permission of CPA Australia. All reproduction requests should be
made in writing and addressed to: Legal, CPA Australia, Level 20, 28 Freshwater Place, Southbank, VIC 3006,
or legal@cpaaustralia.com.au.
Edited and designed by DeakinCo.

Printed by Blue Star Print Group
ISBN 978 1 921742 85 9
Authors
Nikole Gyles Australian Accounting Standards Board (AASB)
Janice Loftus University of Adelaide
Carmen Ridley Australian Financial Reporting Solutions
Dean Hanlon Monash University
CPA Australia would also like to acknowledge the contribution of Catherine Pozzi and earlier contributions
from Phil Hancock and Michael Jones.
2018 updates
Karyn Byrne Consultant
Sorin Daniluc Australian National University
Nikole Gyles Australian Accounting Standards Board (AASB)
Dean Hanlon Monash University
John Kidd Consultant
Janice Loftus University of Adelaide
Alex Martin ANZ
Tiffany Tan Consultant
Helen Yang Victoria University
Advisory panel
Peter Gerhardy Ernst & Young
Shan Goldsworthy Shans Accounting Services
Kris Peach KPMG
Daen Soukseun Department of Transport, Planning and Local Infrastructure, Victoria
Themin Suwardy Singapore Management University
Anne Vuong National Australia Bank
Mark Shying CPA Australia
Ram Subramanian CPA Australia
David Hardidge Telstra
CPA Program team

Neha Abat Kellie Hamilton Shari Serjeant
Yvette Absalom Alex Lawrence Alisa Stephens
Nicola Drury Caroline Lewin Sarah Yang-Spencer
Freia Evans Elise Literski Belinda Zohrab-McConnell
Kristy Grady Sarah Scoble
Educational designers
Deborah Evans and Jane Latchford DeakinCo.
Acknowledgments
This publication contains copyright material of the IFRS Foundation® in respect of which all rights are reserved. Reproduced by
DeakinCo. with the permission of the IFRS Foundation. No permission granted to third parties to reproduce or distribute. For full access
to IFRS Standards and the work of the IFRS Foundation please visit http://eifrs.ifrs.org. The International Accounting Standards Board,
the IFRS Foundation, the authors and the publishers do not accept responsibility for any loss caused by acting or refraining from acting
in reliance on the material in this publication, whether such loss is caused by negligence or otherwise.
This publication contains copyright material from the Australian Securities and Investments Commission (ASIC). © Australian Securities
and Investments Commission. Reproduced with permission. ASIC’s regulatory advice is subject to change. For ASIC’s current regulatory
advice and regulatory publications, please visit www.asic.gov.au/regulatory-resources.
These materials have been designed and prepared for the purpose of individual study and should not be used as a substitute for
professional advice. The materials are not, and are not intended to be, professional advice. The materials may be updated and amended
from time to time. Care has been taken in compiling these materials, but they may not reflect the most recent developments and have
been compiled to give a general overview only. CPA Australia Ltd and Deakin University and the author(s) of the material expressly
exclude themselves from any contractual, tortious or any other form of liability on whatever basis to any person, whether a participant
in this subject or not, for any loss or damage sustained or for any consequence that may be thought to arise either directly or indirectly
from reliance on statements made in these materials.
Any opinions expressed in the study materials for this subject are those of the author(s) and not necessarily those of their affiliated
organisations, CPA Australia Ltd or its members.
Financial Reporting Study map
BEFORE YOU BEGIN
Study guide—Subject outline
Insights for a great semester
BYB
of study
• Important information for

candidates: IFRS® standards
• Red Book 2017: IFRS®
standards selected for MODULE 1
Financial Reporting in the
CPA Program
Study guide
• Study and Exam Information
• Study Companion and Exam
•
Mark Allocations
Appendix (Techworks Ltd
M1
Week 1
Knowledge checks
Ask the expert forum

example financial statements)
• Topic finder
Study time proportion: 10%
• Frequently Asked Questions
• General My Online Learning
administration queries
M2
Weeks 2, 3
MODULE 2
Study guide MODULE 3
Knowledge checks Study guide
M3
• Statement of profit or loss Knowledge checks
and OCI
• Statement of Cash Flows Weeks 3, 4 Ask the expert forum
Ask the expert forum Study time proportion: 10%
MODULE 4
M4
Weeks 4, 5 MODULE 5
Study guide Study guide
Knowledge checks Knowledge checks
Income taxes • Determination of goodwill
Ask the expert forum M5

Weeks 6, 7, 8
•
•
•
Pre-acquisition elimination
Intra-group transactions
Measurement of non-
Study time proportion: 18% controlling interest

MODULE 6
Study guide M6
Weeks 8, 9
Knowledge checks
Ask the expert forum MODULE 7

Study guide
EXAM PREPARATION
M7
Week 10
Knowledge checks
• What to expect in your exam Study time proportion: 10%

• Video tutorial: How to use the
Exam Practice Questions
Key:
Exam Practice Questions
EP
Ask the expert Learning task
• Study companion and Exam forum
Study guide
Mark Allocations Revision Business simulation
Supplementary
• Exam Practice Questions Case study document
User Guide
Knowledge check Video
• Topic finder
ii | FINANCIAL REPORTING
Detailed study session planning

Recommended
study time Done
Before you begin
— Study guide—Subject outline 15 mins
— Video: Insights for a great semester of study 6 mins
— Important information for candidates: IFRS® standards 1 min
— Red Book 2017: IFRS® standards selected for 5 mins

Financial Reporting in the CPA Program
— Study and Exam Information 20 mins
— Study Companion and Exam Mark Allocations 20 mins
— Appendix (Techworks Ltd example financial statements) —

(referred to in Modules 2, 3 and 7)
— Topic finder —
— Ask the expert forum: Frequently Asked Questions and —

General My Online Learning administration queries
Total 67 mins
Notes:
STUDY MAP | iii
Recommended
study time Done
Study
session Module 1—Week 1
1 Study guide—The role and importance of financial reporting 2 hrs
2 Study guide—The Conceptual Framework for Financial 1 hr

Reporting
3 Study guide—Qualitative characteristics of useful financial 2 hrs

information
4 Study guide—The elements of financial statements 2 hrs
5 Study guide—Measurement of elements of financial 3 hrs

statements
6 Study guide—Application of measurement principles in the 4.5 hrs

International Financial Reporting Standards
— Knowledge checks 36 mins
— Ask the expert forum: Module 1—The role and importance —

of financial reporting
Total 15 hrs
Notes:
iv | FINANCIAL REPORTING
Recommended
study time Done
Study
session Module 2—Weeks 2 and 3
1 Study guide—Part A: Presentation of financial statements 4.5 hrs
2 Study guide—Part A: Presentation of financial statements 4.5 hrs

(continued)
3 Study guide—Part B: Statement of profit or loss and other 4 hrs

comprehensive income
— Learning task: Statement of profit or loss and OCI 15 mins
4 Study guide—Part C: Statement of changes in equity 1 hr
5 Study guide—Part D: Statement of financial position 1 hr
6 Study guide—Part D: Statement of financial position 1.5 hrs

(continued)
7 Study guide—Part E: IAS 7 Statement of Cash Flows 3 hrs
8 Study guide—Assumed knowledge review 15 mins
— Learning task: Statement of Cash Flows 1 hr
— Ask the expert forum: Module 2—Presentation of —

financial statements
Total 21.5 hrs
Notes:
STUDY MAP | v
Recommended
study time Done
Study
1 Study guide—Part A: Revenue from contracts with 4.5 hrs

customers
2 Study guide—Part A: Revenue from contracts 3 hrs

with customers (continued)
3 Study guide—Part A: Revenue from contracts with 2 hrs

customers (continued)
4 Study guide—Part B: Provisions 3 hrs
5 Study guide—Part C: Contingent liabilities and 2 hrs

contingent assets
— Ask the expert forum: Module 3—Revenue from contracts —

with customers; Provisions, contingent liabilities and
contingent assets
Total 15 hrs
Notes:
vi | FINANCIAL REPORTING
Recommended
study time Done
Study
1 Study guide—Part A: Income tax fundamentals 4.5 hrs
2 Study guide—Part A: Income tax fundamentals (continued) 4 hrs
3 Study guide—Part B: Recognition of deferred tax assets 2 hrs

and liabilities
4 Study guide—Part B: Recognition of deferred tax assets and 1 hr

liabilities (continued)
5 Study guide—Part B: Recognition of deferred tax assets 3 hrs

and liabilities (continued)
6 Study guide—Part C: Special considerations for assets 3.5 hrs

measured at revalued amounts
7 Study guide—Part D: Financial statement presentation 3.5 hrs

and disclosure
8 Study guide—Part E: Comprehensive example 3 hrs
— Learning task: Income taxes 1 hr
— Ask the expert forum: Module 4—Income taxes —
Total 26 hrs
Notes:
STUDY MAP | vii
Recommended
study time Done
Study
session Module 5—Weeks 6, 7 and 8
1 Study guide—Part A: Business combinations 4.5 hrs
2 Study guide—Assumed knowledge review 30 mins
— Learning task: Determination of goodwill 15 mins
3 Study guide—Part A: Business combinations (continued) 4.5 hrs
4 Study guide—Part B: Consolidated financial statements 4 hrs
— Learning task: Pre-acquisition elimination 1 hr
5 Study guide—Part B: Consolidated financial statements 4.5 hrs

(continued)

(continued)
— Learning task: Intra-group transactions 45 mins
— Learning task: Measurement of non-controlling interest 45 mins

(continued)
8 Study guide—Part C: Investments in associates 3 hrs
9 Study guide—Part C: Investments in associates (continued) 4 hrs
10 Study guide—Part D: Joint arrangements—overview 1 hr
— Ask the expert forum: Module 5—Business combinations —

and group accounting
Total 36 hrs
Notes:
viii | FINANCIAL REPORTING
Recommended
study time Done
Study
1 Study guide—Part A: What are financial instruments? 3 hrs
2 Study guide—Part B: Recognition and derecognition 3 hrs

of financial assets and financial liabilities
3 Study guide—Part C: Classification of financial assets 3 hrs

and financial liabilities
4 Study guide—Part D: Measurement 3 hrs
5 Study guide—Part E: Hedge accounting 4.5 hrs
6 Study guide—Part F: Disclosure issues 3.5 hrs
— Ask the expert forum: Module 6—Financial instruments —
Total 21 hrs
Notes:
STUDY MAP | ix
Recommended
study time Done
Study
session Module 7—Week 10
1 Study guide—Part A: Impairment of assets—an overview 3.5 hrs
2 Study guide—Part B: Impairment of individual assets 4.5 hrs
3 Study guide—Part C: Impairment of cash-generating units 4.5 hrs
4 Study guide—Part D: IAS 36 Impairment of Assets— 2 hrs

disclosure
— Ask the expert forum: Module 7—Impairment of assets —
Total 15 hrs
Notes:
x | FINANCIAL REPORTING
Recommended
study time Done
Exam preparation—Revision
1 Revise Modules 1 and 2 2.5 hrs
2 Revise Modules 3 and 4 3 hrs
3 Revise Module 5 2.5 hrs
4 Revise Modules 6 and 7 2.5 hrs
— Video: What to expect in your exam 7 mins
— Study Companion and Exam Mark Allocations 20 mins
— Video tutorial: How to use the Exam Practice Questions 5 mins
— Exam Practice Questions User Guide 3 mins
— Exam Practice Questions 2 hrs
— Exam Practice Questions: Peer to peer forum —
— Topic finder —
Total 13 hrs
Notes:
FINANCIAL REPORTING
Contents
Subject outline 1
Module 1: The role and importance of financial reporting 9
Module 2: Presentation of financial statements 89
Module 3: Revenue from contracts with customers;

Provisions, contingent liabilities and
contingent assets 195
Module 4: Income taxes 257
Module 5: Business combinations and group accounting 359
Module 6: Financial instruments 517
Module 7: Impairment of assets 605
Appendix 663
FINANCIAL REPORTING
Subject outline
2 | FINANCIAL REPORTING
OUTLINE
Contents
Before you begin 3
Financial Reporting 3
Study guide
My Online Learning
Study plan
Your exam information 6
About the authors 7
SUBJECT OUTLINE | 3
OUTLINE
Before you begin
The purpose of this subject outline is to:
• provide important information to assist you in your studies
• define the aims, content and structure of the subject
• outline the learning materials and resources provided to support learning
• provide information about the exam and its structure.
The CPA Program is designed around five overarching learning objectives to produce future
CPAs who will:
• Be technically skilled and solution driven
• Be strategic leaders and business partners in a global environment
• Be aware of the social impacts of accounting
• Be adaptable to change
• Be able to communicate and collaborate effectively.
For information on dates, fees, rules and regulations, and additional learning support,
please refer to the CPA Australia website: cpaaustralia.com.au/cpaprogram.
Financial Reporting
Financial Reporting is designed to provide you with financial reporting and business skills
that are applicable in an international professional environment. The subject is based on the
International Financial Reporting Standards (IFRSs), which are issued by the International
Accounting Standards Board (IASB). Many international jurisdictions have adopted or are
progressively adopting the IFRSs.
In a competitive international environment, financial reporting provides users with information

to formulate corporate strategies, business plans and leadership initiatives. There is also a common
acceptance of IFRSs for communicating financial information, because they are internationally
understood. This reduces the cost of capital for the international reporting entities.
Financial reporting provides information for corporate leadership. Members of the accounting
profession with financial reporting skills and knowledge provide business advice to board
directors, analysts, shareholders, creditors, colleagues and other stakeholders. Members of the
accounting profession who provide assurance services for financial reports also require a good
understanding of the IFRSs. Directors are also required to state that the financial statements
are fairly stated. These examples reinforce the importance of financial reporting. In addition to
the completion of this subject, CPA Australia encourages continuous professional learning in
financial reporting, which is constantly evolving.
This subject’s technical content includes linkages with the other subjects in the CPA Program.
Financial reporting is a significant part of an entity’s governance and accountability process,
issues that are covered in the subject Ethics and Governance. Compliance with the IFRSs
is important because it results in the presentation of fairly stated financial statements.
This presentation outcome is also the aim of audit and assurance services. The assurance
knowledge and audit skills are taught in the subject Advanced Audit and Assurance.
While taxation is covered in the subject Advanced Taxation, and while it is distinct from
financial reporting, the accounting for tax is recognised as material information and
therefore included in this subject. Financial reporting provides information about the
business operations and the financial results. As a result, there is a relevant topical link
with the subject Contemporary Business Issues.
OUTLINE
On completion of this subject, you should be able to:

• explain the application and basis of selected IFRSs issued by the IASB
• apply IFRSs in the preparation of general purpose financial statements
• explain details relating to general purpose financial statements
• prepare general purpose financial statements for designated entities, including the exercise
of professional judgment.
Study guide
The Study guide is your primary examinable resource and contains all the knowledge you need
to learn and apply to pass the exam. The Financial Reporting Study guide is divided into seven
modules, plus an appendix, and includes a number of features to help support your learning.
These include:
• Objectives—to describe what you are expected to know and be able to do after completing
the module, as well as identify what you’ll be assessed on in the exam.
• Examples—to demonstrate how concepts are applied to real-world scenarios.
• Questions (and suggested answers)—to provide you with an opportunity to assess your
understanding of the key learning points. These questions are an integral part of your study
and should be fully utilised to support your learning of the module content.
• Case studies (and suggested answers)—to help you apply theoretical knowledge to real-life
scenarios, requiring a deep understanding of the module content.
• Teaching materials—this section of your Study guide will inform you of any additional
resources and readings to be referred to in conjunction with the module. Any material that
is listed under ‘Readings’ in this section will be examinable. Any readings that are listed as
‘optional’ will not be examined; they are provided if you wish to explore a particular topic in
more detail.
Suggested texts
Throughout this subject, we apply the accounting standards as presented in the 2017 IFRS
Standards (Red Book) issued on 1 January 2017. This book contains the Conceptual Framework
for Financial Reporting, accounting standards and interpretations as issued at 1 January 2017,
as well as the supporting documents.
All the relevant extracts from the IFRSs that are required for your study and exam purposes are
presented in this Study guide. It is not compulsory to access, print or buy the IFRSs for your study
or exam. If you would like to explore the standards in more detail, you may consult the digital
copy of the relevant IFRSs provided on My Online Learning. You are advised against viewing the
IFRSs from other sources.
CPA Australia encourages you to access the IASB’s website regularly, as it contains many relevant
resources for continuing professional development. However, the IFRSs on the IASB’s website
may not be aligned with the version of the IFRSs used for your study materials, due to frequent
amendments to the standards. You will be examined on the version of the standards used in this
Study guide, which are aligned with the Red Book.
My Online Learning
My Online Learning is CPA Australia’s online learning platform, which provides you with access
to a variety of resources to help you with your study. We suggest you view the video ‘Insights for
a great semester of study’ on My Online Learning, which will provide you with some insights on
how to plan your semester. It will also take you on a guided tour of My Online Learning to show
you how (and when) to access the range of resources available.
SUBJECT OUTLINE | 5
OUTLINE
You will find a wide range of subject-level and module-level resources on My Online Learning.
Subject-level resources are those that apply to the entire subject. These resources can be used
at any time but are most useful when you’ve completed all the modules for the entire subject—
whereas module-level resources should be used while you work through a particular module in
the Study guide.
Some of the resources you may find on My Online Learning include:

• A PDF version of the complete Study guide, as well as a PDF version of each individual module.
• Knowledge checks—these enable you to check your learning for each module and across the
entire subject. You can access these Knowledge checks from any device and retake the test
multiple times.
• Ask the Expert forum—this allows you to post a technical question about the subject content
and have it answered by a subject expert.
• Interactive resources—to help you understand the concepts covered in an engaging manner.
• Exam information—to help you prepare and plan for your exam.
• Study group—to allow you to search for a study group in your area or connect with local
candidates and form your own study group.
You should refer to the journey map located on My Online Learning to see what module
resources you can access and in what order you should use them.
You can access My Online Learning from the CPA Australia website: cpaaustralia.com.au/
myonlinelearning.
Help desk
For help when accessing My Online Learning, either:
• email MemberServices@cpaaustralia.com.au, or
• telephone 1300 73 73 73 (Australia) or +61 3 9606 9677 (international) between 8.30 am
and 5.00 pm (AEST) Monday to Friday during the semester.
Study plan
Total hours of study for this subject will vary depending on your prior knowledge and experience
of the course content. Your individual learning pace and style and your work commitments
will need to be taken into consideration. You will need to work systematically through the
Study guide and readings and attempt all the in-text questions, Case studies and online
Knowledge checks. The workload for this subject is the equivalent of that for a one‑semester
postgraduate unit. An estimated 15 hours of study per week through the semester is
recommended, but additional time may be required for revision.
The ‘Weighting’ column in the following table provides an indication of the emphasis placed on
each module in the exam, while the ‘Recommended proportion of study time’ column is a guide
for you to allocate your study time for each module.
With our flexible study options, you can complete the CPA Program in your own time with access
to national support if you need it. Please refer to the CPA Australia website: cpaaustralia.com.au/
cpaprogram_support.
OUTLINE
Table 1: Module weightings and study time
Recommended
proportion Recommended
of study time Weighting study
Module (%) (%) schedule
1. The role and importance of financial reporting 10 10 Week 1
2. Presentation of financial statements 14 14 Week 2, 3
3. Revenue from contracts with customers; Provisions, 10 10 Week 3, 4

contingent liabilities and contingent assets
4. Income taxes 18 18 Week 4, 5
5. Business combinations and group accounting 24 24 Week 6, 7, 8
6. Financial instruments 14 14 Week 8, 9
7. Impairment of assets 10 10 Week 10
100 100
Your exam information

The Financial Reporting exam is three hours and 15 minutes in duration and comprises multiple-
choice and short-answer questions. Multiple-choice questions include knowledge, application
and problem-solving questions that are designed to assess understanding of Financial Reporting
principles. Short-answer questions focus on the application of concepts and theories from the
subject study materials to solve a given problem.
The Study guide is your central examinable resource. Where advised, relevant sections of the
CPA Australia Members’ Handbook and legislation are also examinable.
This is an open-book exam, so you may bring any reference material into the exam that you
believe to be relevant and that may assist you in undertaking the exam. This may include,
for example, the Study guide, additional materials from My Online Learning, readings and
prepared notes.
You will have access to an on-screen calculator within the computer-based exam environment.
If you are sitting a paper-based exam, we recommend that you bring your own calculator.
Please ensure that the calculator is compliant with CPA Australia’s guidelines. The calculator
must be a silent electronic calculating device the primary purpose of which is calculation.
Calculators with text-storing abilities are not permitted in the exam.
As this exam forms part of a professional qualification, the required level of performance is high.
You are required to achieve a passing scaled score of 540 in all CPA Program exams. Further
information about scaled scores and exam results is available at: cpaaustralia.com.au/cpaprogram.
SUBJECT OUTLINE | 7
OUTLINE
About the authors
Nikole Gyles BCom (Hons) UTas, CA, CPA
Nikole is an Enterprise Fellow at the University of Melbourne,
focusing on developing engagement with the university by
leading and contributing to university–industry linkages,
partnerships and networks as well as to the Executive Education
for Industry program.
Prior to joining the University of Melbourne, Nikole was Technical

Director of the Australian Accounting Standards Board (AASB).
This role involved leading AASB staff in the development and
delivery of the AASB work program across all standard-setting
projects.
Nikole was previously a Director in the Deloitte Accounting

Technical team. In this role, Nikole was responsible for the
management of the Australian IFRS Centre of Excellence,
including analysing and responding to Deloitte global
technical IFRS queries; development and review of international
IFRS publications; and communication of global issues to
Deloitte Australia. Nikole was also responsible for writing and
reviewing technical accounting advice on a wide range of
complex accounting issues.
Janice Loftus BBus NSWIT, MCom (Hons) UNSW, FCPA

Janice is an Associate Professor in Accounting at the
University of Adelaide. Her teaching responsibilities are
primarily in intermediate and advanced financial reporting.
Her current research interests include financial reporting and
corporate social responsibility reporting. Prior to her academic
appointments, Janice held several senior positions in large
Australian companies. She has presented many workshops and
webinars for CPA Australia.
Janice is a co-author of several intermediate financial accounting

textbooks, including Financial Reporting and Applying
International Financial Reporting Standards, in the second and
fourth editions respectively. Other publications include the
AARF Monograph Reporting on Solvency and Cash Condition,
co-authored with Malcolm Miller; several book chapters; and
articles in journals including Abacus, Accounting and Finance,
Accounting, Business and Financial History; Accounting Forum;
Advances in International Accounting; Australian Accounting
Review; Australian Journal of Corporate Law; Financial
Reporting; Regulation and Governance; and the Journal of
Business Ethics. Janice is a member of the executive committee
of the Accounting Standards Interest Group of the Accounting
and Finance Association of Australia and New Zealand.
OUTLINE
Carmen Ridley BSc (Hons) Mathematics, FCA

Carmen is the Principal of Australian Financial Reporting
Solutions (AFRS). She has been in auditing and accounting
roles for more than 17 years, and she has worked in the technical
department of a Big-4 firm prior to running the technical auditing
and accounting divisions of a couple of mid-tier firms.
Carmen provides technical auditing and accounting services for a

range of clients and ensures that she keeps up to date and aware
of current accounting and auditing issues. She has established
herself as a recognised expert in financial reporting arenas.
Carmen is a board member of the Australian Accounting

Standards Board.
Carmen is also a key speaker for CPA Australia, having written

and presented a number of financial reporting professional
development courses, and she is a regular speaker at
CPA congresses and conferences.
Dean Hanlon BEc, GradDipCom, MCom (Hons),

PhD Monash University, CPA, CA
Dean is a senior lecturer in the Department of Accounting at
Monash University. His current teaching responsibilities are in
advanced financial accounting and, as Honours coordinator,
contemporary research issues in financial accounting. He has
been recognised for his pedagogy at the faculty, university
and national level as the recipient of several teaching
excellence awards.
Dean’s current research interests are in financial reporting

and taxation. He has presented his research at numerous
international and domestic conferences, having won best
paper awards on several occasions. He has been the
recipient of several competitive research grants and has
published his research in journals including Accounting
and Finance, Australian Accounting Review, Australian Tax
Forum, Australian Tax Review, Journal of Contemporary
Accounting and Economics and Pacific-Basin Finance Journal.
Dean is a member of the CPA Australia External Reporting

Centre of Excellence and the Advanced Taxation Advisory
Panel, and has served on the Technical Committee of
the Accounting and Finance Association of Australia and
New Zealand. He has also presented many workshops
and webinars within the CPA Program.
FINANCIAL REPORTING
Module 1
THE ROLE AND IMPORTANCE OF
FINANCIAL REPORTING
10 | THE ROLE AND IMPORTANCE OF FINANCIAL REPORTING
Contents
Preview 11
Introduction
Objectives
MODULE 1
Teaching materials
Information to CPA Program candidates studying Financial Reporting
2017 International Financial Reporting Standards—the Red Book
Rounding
The role and importance of financial reporting 13
The role of financial reporting
The importance of financial reporting
What are the different types of financial reporting for users?
Understanding the International Financial Reporting Standards
Non-International Financial Reporting Standards reporting
Limitations of general purpose financial reporting
Who must prepare general purpose financial reports? Interaction between
financial reporting and the regulatory environment
International initiatives to decrease financial reporting complexity
The Conceptual Framework for Financial Reporting 24
The purpose and application of the Conceptual Framework
Principles established in the Conceptual Framework
Qualitative characteristics of useful financial information 28
Fundamental qualitative characteristics
Enhancing qualitative characteristics
The cost constraint on useful financial reporting
Application of qualitative characteristics in the International Financial
Reporting Standards
The elements of financial statements 35
Defining the elements of financial statements
Criteria for recognising elements of financial statements
Constraints on frameworks
Measurement of elements of financial statements 40
Valuation techniques
Application of measurement principles in the International Financial
Reporting Standards 55
Leases
Employee benefits
Accounting for share-based payments
Investment property
Professional judgment
Disclosures
Review 76
Suggested answers 77
References 87
Optional reading
Study guide | 11
Module 1:
The role and importance
MODULE 1
of financial reporting
Study guide
Preview
Introduction
Financial reporting is the process of documenting an entity’s financial status in the form of
financial reports/statements. The entity uses the prepared financial reports as a communication
tool to assist users with their decision-making. Financial reports are accessed by a broad range
of users, including shareholders, banks and other creditors, competitors, employees and financial
analysts. Therefore, to assist users in their decision-making, it is critical that financial statements
are prepared in accordance with a recognised financial reporting framework.
The use of accounting standards as a consistent language for reporting ensures that financial
statements are understandable and can be compared among entities. International Financial
Reporting Standards (IFRSs) are the global language of accounting standards. This module
considers the role and importance of financial reporting and discusses the application of reporting
in an international context. It then discusses the need for general purpose financial statements
(GPFSs) and the role that the Conceptual Framework for Financial Reporting (Conceptual
Framework) plays in financial reporting. We also discuss the limitations of frameworks.
In discussing the definitions and recognition criteria outlined in the Conceptual Framework,
this module examines their application in IFRSs in the context of selected issues. Measurement is
a complex and controversial aspect of accounting. In this module, alternative measurement bases
are studied, and the application of the mixed measurement model is examined. Measurement
issues in relation to liabilities and expenses are considered in the context of leases, employee
benefits and share-based payments. The module also explores the application of the
Conceptual Framework in the context of investment properties.
Objectives
After completing this module you should be able to:
• explain the role and importance of financial reporting;
• explain the role of the IASB Conceptual Framework in financial reporting and
accounting standards;
MODULE 1
• describe the objective and limitations of general purpose financial statements as identified
in the Conceptual Framework;
• explain the definitions of the elements of financial statements and recognition criteria
adopted by the Conceptual Framework;
• explain the application of the standards to the financial reporting process and apply
specific standards;
• discuss and demonstrate the importance of professional judgment in the financial
reporting process;
• explain the implications of using cost and fair value accounting; and
• explain how materiality is assessed and determine the materiality of transactions.
Teaching materials
International Financial Reporting Standards (IFRS), 2017 IFRS Standards (Red Book), and the
following International Accounting Standards (IASs):
• IASB The Conceptual Framework for Financial Reporting (2010)
• IFRS 2 Share-based Payment
• IFRS 5 Non-current Assets Held for Sale and Discontinued Operations
• IFRS 9 Financial Instruments
• IFRS 13 Fair Value Measurement
• IFRS 16 Leases
• IAS 1 Presentation of Financial Statements
• IAS 2 Inventories
• IAS 8 Accounting Policies, Changes in Accounting Estimates and Errors
• IAS 16 Property, Plant and Equipment
• IAS 19 Employee Benefits
• IAS 36 Impairment of Assets
• IAS 37 Provisions, Contingent Liabilities and Contingent Assets
• IAS 40 Investment Property
Information to CPA Program candidates studying

Financial Reporting
Candidates enrolled in Financial Reporting will note that the IFRS’s (Red Book 2017) are used
in the study materials. All the relevant extracts from the IFRSs required for your study and exam
purposes are presented in this study guide. It is not compulsory to access, print or purchase
the IFRSs for your study or exam. Candidates who would like to explore the standards in more
detail may consult the digital copy of the IFRSs, which is provided on My Online Learning in the
‘Learning Resources and Additional Information’ folder. You can access the IFRSs from the
website of the International Accounting Standards Board (IASB), but please note that the IFRSs
on the website of the IASB’s website may not be aligned with the version of the IFRSs used in this
edition of the Financial Reporting Study guide due to frequent amendments to the standards.
The exam will cover the version of the standards used in the study guide, which are aligned with
the Red Book 2017.
Study guide | 13
2017 International Financial Reporting Standards—the Red Book

Throughout this subject, the accounting standards issued as at 1 January 2017 as presented in
the 2017 Red Book are applied. The book is presented in two parts:
• Part A includes the Conceptual Framework, as well as all of the accounting standards and
interpretations as issued at 1 January 2017.
MODULE 1
• Note that the paragraph references for the Conceptual Framework start with the letters OB
for Chapter 1 and QC for Chapter 3.
• Part B includes all of the supporting documents for the Conceptual Framework accounting
standards and interpretations as issued at 1 January 2017. These supporting documents
include:
–– the basis of conclusions and, for some accounting standards, the dissenting opinions
–– implementation guidance
–– details of amendments and impacts on other accounting standards
–– illustrative examples.
Rounding
In this subject, the questions and examples are sometimes rounded to the nearest dollar or
thousands of dollars. In financial reporting, rounding is used in preparing financial statements,
but any requirement to round is jurisdiction-specific and is not a requirement of the IFRSs.
In this subject, where decimal places are used, all rounding should be to two decimal places
unless otherwise stated.
The role and importance of financial reporting

Financial reporting is a process that provides entities with an important communication
tool allowing the management of an entity (preparers) to produce financial information for
external stakeholders (users). Financial statements are the key financial reporting tool that
preparers use to communicate to users. Financial statements provide users with information
about how an entity is being managed, including its financial position, financial performance
and cash flows.
The role of financial reporting

The role of financial reporting is to provide users with information to enable them to achieve
effective decision-making. It also provides a stewardship or accountability role by requiring
managers to give an account of how they have used the resources provided.
Identification of the primary users of general purpose financial reports is crucial. The IASB
categorises primary users as those that provide debt or equity to the entity. Specifically,
the primary users of an entity’s financial information are existing and potential investors,
lenders and other creditors (Conceptual Framework, para. OB2). For example, investors
may use financial statements to make decisions about when and how to invest their money,
including assessing how well the management of an entity has run the entity.
Effective financial reporting communicates the ‘story’ of the entity during the period so that
the users can understand what the entity has achieved and how it has achieved it. Improving the
communication effectiveness of financial statements is one of the central themes of the IASB’s
standard-setting work (IFRS Foundation 2016a).
Financial reporting sits in a framework of other reporting provided by an entity. Other types of
reporting include investor updates, sustainability reporting, corporate governance reporting
and other prospective, or forward-looking, information. For example, when an entity is intending
to list on a stock exchange, it would normally be required to provide some forward-looking
information to potential investors to help them make their investment decision.
MODULE 1
Financial reports provide information about an entity’s financial position, and the effects
of transactions and other events that give rise to changes in an entity’s financial position
(Conceptual Framework, paras OB12–OB16). The presentation of financial reports is prescribed
to ensure that they are comparable with the entity’s previous financial statements and with
the financial statements of other entities (IAS 1, para. 1). The statement of financial position
(or balance sheet) provides information about the financial position of the entity. The statement
of profit or loss and other comprehensive income (P&L and OCI) (also referred to as the
‘statement of financial performance’ or just ‘profit or loss statement’) reports on performance
on an accrual basis. The statement of cash flows reports on performance on a cash basis.
Changes in the net assets, or equity, are reported in the statement of changes in equity.
The importance of financial reporting

Financial reporting is important because of the often significant level of resources under the
responsibility of managers and the financial impact of the decisions made by users based
on this information. This importance is reflected in company regulators and stock exchanges
around the world requiring financial statements to be prepared by entities as part of their
reporting obligations.
The types of decisions that financial statements might be used for are highlighted in Figure 1.1.
Figure 1.1: Financial statement user decisions
Shareholders Competitors
Should I invest money How has the company

in the company? performed in comparison
to its competitors?
?
Suppliers Banks
Should I sell goods Should I lend money

to the company? to the company?
Source: CPA Australia 2016.

Study guide | 15
Information needs of the user

As previously mentioned, the primary users of financial information are existing and potential
investors, lenders and other creditors (Conceptual Framework, para. OB2). Other users of
financial information include regulators and members of the public, such as community groups
and potential employees. Many of these users are unable to require specific information to
MODULE 1
be provided directly to them and must therefore rely on general purpose financial reports.
Entities are required to prepare general purpose financial reports specifically to assist their
primary users in their decision-making. The information needs of these users may differ.
For example, current investors are interested in deciding whether to hold or sell their investment,
whereas potential investors are interested in deciding whether or not to buy an investment.
These decisions may give rise to varying or even conflicting information needs.
The IASB’s approach to resolving conflicting user information needs is to provide the information
that will meet ‘the needs of the maximum number of primary users’ (Conceptual Framework,
para. OB8). However, it is noted that focusing on common information needs does not prevent
an entity from providing additional information that may be useful to another sub-group of
primary users (Conceptual Framework, para. OB8).
Conflicting information needs are shown in Figure 1.2. The shaded area represents the common
information needs of primary user groups. Conflict arises where the information needs do not
overlap, as indicated by the unshaded areas, and where the information needs of only two user
groups are shared (striped areas). The unshaded and the striped areas depict differing information
needs, where choices made by standard setters and preparers may result in the needs of some
primary users being met at the expense of the needs of other primary users.
Figure 1.2: Maximising the number of primary users whose information

needs are met
Investors Lenders
Other creditors
Source: Adapted from IFRS Foundation 2017, Conceptual Framework for Financial Reporting,
paras OB5–OB8, in 2017 IFRS Standards, IFRS Foundation, London, pp. A27–8. © CPA Australia 2015.
Consider, for example, lenders as users of financial statements. Lenders are interested in
making an assessment of an entity’s capacity to meet its principal and interest obligations and
the level of risk associated with a loan. As investors invest equity, they are also interested in the
assessment of risk and the ability of the entity to service its debt, so that the entity can continue
its operations and provide a return to investors.
These varying demands may give rise to different preferences for the measurement of assets or
the timing of the recognition of revenue. For example, creditors may prefer a measure of the net
realisable value of certain assets to assess whether the security is sufficient in the event that the
entity defaults on repayment. However, investors may prefer measurement based on value in use,
which provides a better indication of the expected benefits to be derived from the continued
use of the assets.
Trying to meet the needs of the maximum number of primary users may have different
implications depending on the context. For example, for some entities, investors may be the
largest group of primary users, but for other entities, the larger group of primary users may
be lenders.
MODULE 1
➤➤Question 1.1
According to the Conceptual Framework, who are the primary users of general purpose financial
reports, and why do you think they are regarded as the primary users?
Check your work against the suggested answer at the end of the module.
➤➤Question 1.2
Consider the following statement:
By focusing on the information needs of investors, lenders and other creditors, financial
reporting will not be useful for other users.
Do you agree or disagree? Give reasons for your answer.
Limitations of the decision-usefulness objective

The objective of financial reporting is to provide financial information that will be useful to
the maximum number of primary users for their decision-making. It is not possible for entities
to provide all information about the financial position, performance and changes in financial
position to a wide range of users. Preparers of the financial reports are required to exercise
some judgment in deciding which information is required for it to be useful. Consider the
following problems.
Study guide | 17
• Lack of familiarity with new types of information: If users of financial statements are not
familiar with an item of information, it is difficult to assess its usefulness to the users’ decision
making processes. Users are unable to incorporate information into their decision making
if it is not disclosed. For example, a new item of information in the financial reports may be
recognised under an existing category and not disclosed separately. Without this separate
MODULE 1
disclosure, it may be difficult for users who are unfamiliar with the item to determine if it is
useful in their decision-making process.
• Decision-usefulness may vary among users: For example, some investors may consider
environmental performance to be relevant, whereas others might exclude it from their
decision-making models. The differences in what users find relevant are likely to depend
on the decision being made. For example, the information needs of customers deciding
whether to enter into a long-term purchase contract will differ from the needs of employee
representative groups negotiating remuneration and working conditions for employees.

• Capable of multiple interpretations: The decision-usefulness criterion appears to be
capable of supporting different measurement bases. For example, using fair value as the
relevant measurement attribute may support capital market assessments of the required
rate of return on assets of equivalent risk, whereas entity-specific measurement attributes
(such as value in use) may be consistent with management’s plans and expectations regarding
particular assets. These competing user needs are difficult to reconcile under the currently
specified objective of general purpose financial reporting.
➤➤ Question 1.3
Consider the following statement:
The decision-usefulness objective provides unambiguous guidance in resolving financial
reporting problems.
Do you agree? Give reasons for your answer.
What are the different types of financial reporting for users?

We can split financial reporting into two types: general purpose financial reporting and special
purpose financial reporting.
As outlined in Table 1.1, whether general purpose or special purpose financial reporting is
appropriate depends on whether the target users of the financial reporting are able to request
specifically tailored reports to meet their needs.
Table 1.1: Use of different financial reporting types
Source of decision‑making
Type of financial reporting Users information
MODULE 1
General purpose financial Unable to request reports to meet GPFSs

reporting (broad focus) their particular information needs
(e.g. investors)
Special purpose financial In a position to request that the entity Special purpose financial
reporting (narrow focus) prepares reports to meet their particular statements (SPFSs)
information needs (e.g. banks, regulators)
For example, a bank extending credit

to a corporate customer may require
information about the timing of expected
cash receipts and payments.
In this module, the terms ‘financial reports’ and ‘financial reporting’ refer to general purpose
financial reports and general purpose financial reporting unless otherwise noted. GPFSs such
as the P&L and OCI, statement of financial position, statement of changes in equity, and the
statement of cash flows and the notes make up the body of general purpose financial reports
that are prepared for external users.
Understanding the International Financial Reporting Standards

The IFRSs are ‘an internationally recognised set of accounting standards that bring transparency,
accountability and efficiency to financial markets around the world’ (IFRS Foundation 2017a).
IFRSs are used by most publicly listed companies in over 120 jurisdictions and were adopted by
Australian entities required to report under the Corporations Act 2001 (Cwlth) (Corporations Act)
for annual reporting periods beginning on or after 1 January 2005.
There are two series of international accounting standards. The first series, the International
Accounting Standards (IASs), are those standards issued from 1973 to 2001, before the
new International Accounting Standards Board (IASB) was formed. The second series,
the International Financial Reporting Standards (IFRSs), are those standards issued under the
IASB since 2001 and reflect the changes in accounting and business practices since that
date (Kivumbi 2010). Some IASs are still relevant today and have therefore remained under
their original IAS heading. An example is IAS 1 Presentation of Financial Statements.
AASB standards (AASBs) are the accounting standards developed by the Australian Accounting
Standards Board for all economic sectors in Australia. A specific numbering system has been
used for the AASBs to identify their adoption into the international accounting standards.
AASBs numbered from 1 to 100 are the equivalent of IFRSs. AASBs numbered from 101 are
the equivalent of IASs; and AASBs numbered from 1001 have no international equivalent
(AASB 2017a). The AASBs, whilst complying with the IFRSs, include additional paragraphs where
reporting requirements differ for specific economic entities such as Australian not-for-profit
entities. These paragraphs have the prefix ‘AUS’ or ‘RDR’ (Reduced Disclosure Requirements)
and generally begin with words that highlight their limited applicability. For example:
“Notwithstanding paragraphs xx, in respect of not-for-profit entities …”.
Study guide | 19
Each standard includes a statement at the beginning referring to its structure, main principles
and terms, and the context in which the standard should be read. Example 1.1 shows this
statement as is included at the beginning of IFRS 16 Leases.
MODULE 1
Example 1.1: Statement from IFRS 16 Leases
IFRS 16 Leases is set out in paragraphs 1–103 and Appendices A–D. All the paragraphs have equal
authority. Paragraphs in bold type state the main principles. Terms defined in Appendix A are in italics
the first time that they appear in the Standard. Definitions of other terms are given in the Glossary
for International Financial Reporting Standards. The Standard should be read in the con-text of its
Objective and the Basis for Conclusions, the Preface to International Financial Reporting Standards and
the Conceptual Framework for Financial Reporting. IAS 8 Accounting Policies, Changes in Accounting
Estimates and Errors provides a basis for selecting and applying accounting policies in the absence
of explicit guidance.
Source: IFRS Foundation 2017, IFRS 16 Leases, in 2017 IFRS Standards,

IFRS Foundation, London, p. A721.
Each standard begins with statements on its Objective and Scope and includes a section for its
Effective Date (ED) and whether earlier adoption is permitted. Additional sections such as the
Basis for Conclusions (BC) and the Illustrative Examples (IE) accompany the standard, but are not
considered to be a part of the standard. The BC section provides detailed explanations of the
IASB’s considerations when developing and/or updating the standard. The IE section is included
for those Standards requiring practical explanations and may provide examples to demonstrate
the application of the main principles of the standard. The IEs are not meant to represent the only
application of a particular aspect and are not intended to be industry-specific. Example 1.2 is taken
from the Illustrative Examples section of IFRS 16 Leases. It includes Example 5 which works through
identifying whether or not a lease exists for a truck rental contract. When a member (or members)
of the IASB does not approve the publication of a standard, that standard will include a section
called Dissenting Opinion (DO) which states the reasons for any member objections.
Example 1.2: IFRS 16 Leases, Illustrative Example 5—

Truck Rental
Customer enters into a contract with Supplier for the use of a truck for one week to transport cargo
from New York to San Francisco. Supplier does not have substitution rights. Only cargo specified in
the contract is permitted to be transported on this truck for the period of the contract. The contract
specifies a maximum distance that the truck can be driven. Customer is able to choose the details of
the journey (speed, route, rest stops, etc.) within the parameters of the contract. Customer does not
have the right to continue using the truck after the specified trip is complete.
The cargo to be transported, and the timing and location of pick-up in New York and delivery in
San Francisco, are specified in the contract.
Customer is responsible for driving the truck from New York to San Francisco.
The contract contains a lease of a truck. Customer has the right to use the truck for the duration of
the specified trip.
There is an identified asset. The truck is explicitly specified in the contract, and Supplier does not have
the right to substitute the truck.
Customer has the right to control the use of the truck throughout the period of use because:
(a) Customer has the right to obtain substantially all of the economic benefits from use of the truck
over the period of use. Customer has exclusive use of the truck throughout the period of use.
(b) Customer has the right to direct the use of the truck because the conditions in B24(b)(i) exist.
How and for what purpose the truck will be used (ie the transportation of specified cargo from
MODULE 1
New York to San Francisco within a specified timeframe) is predetermined in the contract. Customer
directs the use of the truck because it has the right to operate the truck (for example, speed,
route, rest stops) throughout the period of use. Customer makes all of the decisions about the
use of the truck that can be made during the period of use through its control of the operations
of the truck.
Because the duration of the contract is one week, this lease meets the definition of a short-term lease.
Source: IFRS Foundation 2017, IFRS 16 Leases, in 2017 IFRS Standards,

IFRS Foundation, London, p. B1898.
If you wish to explore this topic further, refer to IFRS 16 Leases, reading from the title page up to and
including paras 1–4 of the standard. You may also refer to IFRS 16 IE section for further illustrative
examples on the application of the standard.
Non-International Financial Reporting Standards reporting

Not all entities are required to prepare financial reports in accordance with the IFRSs. An entity
may use alternative bases for accounting if this is required or permitted. For example, in Malaysia,
private entities comply with the Malaysian Private Entities Reporting Standard (MPERS) rather
than with the IFRSs. Alternatively, an entity that is not required to report separately in accordance
with the IFRSs may still need to provide information to a parent entity for inclusion in a set of
consolidated financial statements that must comply with the IFRSs. This module and this subject
will only address an entity’s obligations under the IFRSs.
Furthermore, although the IFRSs and the Conceptual Framework are also applied in the
not‑for‑profit sector in some jurisdictions, emphasis throughout this subject is on profit-seeking
entities in financial markets.
Limitations of general purpose financial reporting

Due to time and cost constraints in preparing general purpose financial reports, it is not possible
for entities to provide useful information that will meet the varying needs of users. When a user
requires specific information that has not been disclosed in an entity’s financial reports, the IASB
recommends the use of other sources such as ‘general economic conditions and expectations,
political events and political climate, and industry and company outlooks’ (Conceptual
Framework, para. OB6) to help gain a clearer understanding. The IASB also explains that the
financial reports are ‘not designed to show the value’ of the organisation but to help decision-
makers make their own estimates as to its value (Conceptual Framework, para. OB7).
If you wish to explore this topic further, read paras OB6–OB11 of the Conceptual Framework
(in Part A of the Red Book).
Who must prepare general purpose financial reports?

Interaction between financial reporting and the
regulatory environment
The IFRSs are silent on which entities should prepare general purpose financial reports.
Such matters are considered to be better left to governments and regulatory agencies in
each jurisdiction. Reporting obligations for entities are usually set out in local legislation and
other regulatory requirements.
Study guide | 21
In Australia, the reporting obligations for companies are found in Part 2M.3 (Financial Reporting)
of the Corporations Act. This includes s. 292, which specifies that financial reports must
be prepared by all disclosing entities, public companies, large proprietary companies and
registered schemes, and s. 296 stipulates that the financial report must comply with accounting
standards. The obligations of other types of entities are included in other federal or state-based
MODULE 1
legislation. For example, for associations, the appropriate legislation is the relevant state-based
Incorporated Associations Act.
In other jurisdictions, the appropriate legislation includes the Financial Markets Conduct Act 2013
(New Zealand) and the Financial Reporting Act 2013 (New Zealand), Singapore Companies Act
1969 (Singapore) and the Companies Act 1965 (Malaysia). The legislation will specify the content
of the financial statements, the regularity of reporting and the basis on which the financial
statements are prepared.
In addition to formal regulations, there are examples of guidance on who should prepare reports
based on professional judgment linked to the needs of external users. For example, in Australia,
Statement of Accounting Concept (SAC) 1, para. 41, states that ‘reporting entities shall prepare
general purpose financial reports … in accordance with accounting standards’ (Australian
Accounting Research Foundation & Accounting Standards Review Board (AARF & ASRB 1990).
In para. 40, it also defines reporting entities based on user needs rather than the organisation’s
legal structure or physical size:
Reporting entities are all entities (including economic entities) in respect of which it is reasonable to
expect the existence of users dependent on general purpose financial reports for information which
will be useful to them for making and evaluating decisions about the allocation of scarce resources
(AASB, SAC 1).
The actual financial reporting undertaken by an entity depends on the type of organisation and
the jurisdiction in which it operates. The regulatory environment will specify which standards
require compliance as well as any additional reporting requirements.
The objective of general purpose financial reporting is to provide useful financial information to
various users to support their decision-making needs. In addition, there is a stewardship function,
which involves reporting on how efficiently and effectively management has used the resources
entrusted to it. Chapter 1 of the Conceptual Framework discusses these objectives in greater
detail, and it identifies potential users and the types of decisions that they may need to make.
If you wish to explore this topic further, read paras OB1–OB5 of the Conceptual Framework
(in Part A of the Red Book).
International initiatives to decrease financial reporting complexity

An ongoing criticism of financial reporting is the complexity of financial reports. Improving the
communication effectiveness of financial reporting is a current focus of the IASB (IFRS Foundation
2016b), and there are a growing number of initiatives to help combat the issue, including:
• reducing differences in reporting standards among countries
• reducing reporting requirements of specific organisations
• catering to the information needs of multiple stakeholders.
Some examples of these initiatives are described as follows.

Overall, the complexity in financial reporting has decreased due to increased acceptance of
the IFRSs in most parts of the world. More than 120 jurisdictions worldwide require the use of the
IFRSs for their publicly listed companies (IFRS Foundation 2017b).
The global acceptance of the IFRSs led to the commitment of the US Financial Accounting
Standards Board (FASB) to work with the IASB to explore the possibilities of convergence of
US Generally Accepted Accounting Principles (GAAP) with the IFRSs. In 2007, the US Securities
and Exchange Commission (SEC) eliminated the requirement for foreign companies listed on the
US SEC to reconcile their IFRSs-based financial statements to US GAAP. However, the US SEC
MODULE 1
does not permit domestic issuers to adopt the IFRSs (SEC 2007).
Reducing reporting requirements of specific organisations

The complexity of the full IFRSs led the IASB and accounting standards-setting bodies to
specify less complex standards for some entities. Examples of such reductions are as follows.
International Accounting Standards Board

To reduce the complexity of following the full IFRSs for small and medium-sized entities (SMEs),
the IASB has introduced the IFRS for SMEs. The IFRS for SMEs is described as being less complex
than the ‘full’ IFRSs because of the following:
• Topics not relevant to SMEs, such as earnings per share, interim financial reporting and
segment reporting, are omitted.
• Many principles for recognising and measuring assets, liabilities, income and expenses in
the full IFRSs are simplified—for example, amortised goodwill, expense all borrowings and
development costs; cost model for associates and jointly controlled entities; and undue cost
or effort exemptions for specific requirements.
• Significantly fewer disclosures are required (about a 90% reduction).
• The standard is written in clear, easily understandable language.
To further reduce the burden on SMEs, revisions are expected to be limited to once every three
years (IFRS Foundation 2016c).
Australian Accounting Standards Board

In 2009, the AASB introduced a differential reporting framework that organisations meeting the
category of Tier 2 can follow, ‘Tier 2: Australian Accounting Standards—Reduced Disclosure
Requirements (RDR)’ (see AASB 2017b). In contrast, others need to follow the full standards.
The RDR is available to a wide range of entities in both the private and public sectors in preparing
general purpose financial statements:
(a) for-profit private sector entities that do not have public accountability;
(b) all not-for-profit private sector entities; and
(c) public sector entities other than the Australian Government and State, Territory and Local
Governments (AASB 2017c).
External Reporting Board (New Zealand)

In 2012, the External Reporting Board (XRB) (New Zealand) issued a multi-tiered accounting
standards framework in which the level of disclosure and compliance requirements depend
on the nature of the organisation. Firstly, organisations are categorised as either ‘for-profit’
entities or ‘public-benefit’ (not-for-profit) entities. These entities are then further classified as to
whether they are publicly accountable for filing their financial reports, and/or their size (a small
to medium-sized entity or a large entity). This multi-tiered approach is summarised in Table 1.2.
Study guide | 23
Table 1.2: External Reporting Board Accounting Standards Framework

tiered approach
For-Profit Entities Public Benefit Entities
MODULE 1
Accounting Accounting
Entities Standards Entities Standards
Tier 1 Publicly accountable NZ IFRS Publicly accountable PBE Standards

(as defined); or (as defined); or
Large (as defined) Large (as defined)
for‑profit public
sector entities
Tier 2 Non-publicly NZ IFRS Reduced Non-publicly PBE Standards

accountable and Disclosure Regime accountable Reduced
Non-large for-profit (NZ IFRS RDR) (as defined) Disclosure Regime
public sector entities and non‑large (PBE Standards RDR)
which elect to be (as defined)
in Tier 2 which elect to
be in Tier 2
Tier 3 Non-publicly PBE Simple Format

accountable Reporting Standard -
(as defined) with Accrual (PSFR-A)
expenses ≤ $2 million
which elect to be
in Tier 3
Tier 4 Entities allowed PBE Simple Format

by law to use cash Reporting Standard -
accounting Cash (PSFR-C)
which elect to
be in Tier 4
Source: External Reporting Board (New Zealand) 2017, ‘Accounting standards framework: Overview’,
accessed November 2017, https://www.xrb.govt.nz/why-report/accounting-standards-framework.
Catering to the information needs of multiple stakeholders

One aspect of the current complexity in reporting, which has attracted the attention of accounting
standards-setting bodies worldwide, has resulted from the need to measure ‘performance’
from multiple perspectives. This requirement cannot be met simply by the reporting of financial
statements. A company’s performance is a multifaceted measure. Therefore, there is a need for
information such as the progress of the company––in terms of strategy and plan––rather than
financial measures such as profit, assets and liabilities. Although the reporting of the strategy and
plan is material to investors, lenders and other stakeholders, there is no requirement to report
this information in the IFRSs.
The increase in the reporting of non-mandatory information in annual reports (relative to the
financial section) makes financial reporting seem like a mere compliance exercise rather than an
exercise that communicates the information needs of multiple stakeholders (IFRS Foundation
2017e). Some of the present research projects in progress across the world are as follows.
International Accounting Standards Board

In response to user and preparer concerns about the increasing complexity of IFRS requirements,
the IASB has been working on multiple projects to reduce the complexity of financial reporting.
Some of the key initiatives of the IASB are outlined below.
MODULE 1
Principles of disclosure
he aim of this research project is to develop a disclosure standard that assists entities to
T
communicate their disclosures more effectively. The focus includes IAS 1 Presentation of Financial
Statements and IAS 8 Accounting Policies, Changes in Accounting Estimates and Errors.
Standards level review of disclosure

he aim of the Standards-Level Review of Disclosures project is to improve disclosure related
T
to the respective standards, with the principles of the disclosure project informing such
improvement (IFRS Foundation 2017d).
Materiality
he aim of this project is to provide guidance on the application of materiality to help preparers
T
of financial statements, auditors and regulators to report material information. The discussion
stems from whether the definition of ‘materiality’ needs to clarify that materiality is not only
enhanced by reporting of material information but also by reducing disclosure of overwhelming
and distracting immaterial information (IFRS Foundation 2017e).
Financial Reporting Council (UK)

To improve corporate reporting so that it provides a ‘clearer understanding of the underlying
performance of a company’ (FRC 2017), the FRC introduced the Financial Reporting Lab in 2011
as a forum for companies and investors to solve contemporary reporting needs. The lab works
with 65 companies, 60 investment organisations and more than 300 retail investors with the aim
of improving disclosures. Two of the themes that the lab focuses on are ‘Digital Present’ and
‘Towards Clear & Concise Reporting’ (FRC 2017).
Summary
Accounting standard-setters have had a renewed focus on reducing complexity in financial
reporting. However, challenges still exist regarding the development of an overarching disclosure
model to measure performance without increasing the complexity of financial reporting.
The Conceptual Framework for Financial Reporting

In this section we look at the IASB Conceptual Framework for Financial Reporting (Conceptual
Framework).
The Conceptual Framework sets out the concepts that underlie the preparation and presentation
of financial statements for external users (Conceptual Framework, ‘Purpose and status’).
In September 2010, the IASB issued a version of the Conceptual Framework that partially
updated the previous (1989) version. The IASB is in the process of updating and improving the
2010 Framework. However, in this module and throughout this subject, only the 2010 version
of the Conceptual Framework, which is found in Part A of the Red Book, is considered.
Study guide | 25
The Conceptual Framework is structured as shown in Table 1.3.
Table 1.3: Structure of the Conceptual Framework for Financial Reporting
MODULE 1
Chapter Content
Introduction Provides a detailed description of the purpose, status and scope

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

• Includes paragraphs identified as ‘OB’ before their
paragraph numbers
2. Reporting entity • Content not yet been included; to be developed as part of the
current Conceptual Framework revision project
3. Qualitative • Provides guidance on the qualitative characteristics of useful

characteristics financial information
• Includes paragraphs identified as ‘QC’ before their
paragraph numbers
4. Remaining text of the • Includes the rest of the Conceptual Framework

1989 Framework • Sets out the going concern assumption as well as the definitions
of the elements of financial statements and the recognition criteria
The purpose and application of the Conceptual Framework will now be discussed, and its
components will be examined in detail.
The purpose and application of the Conceptual Framework

Accounting standards do not cover all possible transactions an entity may enter into.
When standards do not provide guidance or sufficiently specific guidance, it is the role
of the Conceptual Framework to provide guidance to facilitate consistency in the reporting
of transactions and events.
Having a common framework is an important foundation in guiding the development

of accounting standards and accounting practice.
The Conceptual Framework provides a formal frame of reference for:

• the types of transactions and events that should be accounted for
• when transactions and events should be recognised
• how transactions and events should be measured
• how transactions and events should be summarised and presented in financial statements.
For example, IAS 36 Impairment of Assets applies the principle that the carrying amount of an
asset should not exceed its recoverable amount. This principle is consistent with the concept of
an asset adopted in the Conceptual Framework:
a resource controlled by the entity as a result of past events and from which future economic
benefits are expected to flow to the entity (para. 4.4).
As an asset represents a resource that provides future benefits, the amount at which it is reported
in the statement of financial position should not exceed the expected benefits to be derived
from the asset.
The Conceptual Framework can be applied in several ways, as shown in Table 1.4.
Table 1.4: Applying the Conceptual Framework for Financial Reporting

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Who is applying the

Conceptual Framework How the Conceptual Framework is applied
Standard setters To develop accounting standards
Preparers Guidance when issues that are not directly covered by a standard or
interpretation arise (Specifically, IAS 8 Accounting Policies, Changes in
Accounting Estimates and Errors requires the Conceptual Framework to be
considered when there is an absence of a specific accounting standard or
interpretation (IAS 8, paras 10–11)).
Auditors To help form an opinion on compliance with an IFRS
Users To better understand and interpret the financial reports they are reviewing
Where there is a conflict with an IFRS, the requirements of the particular standard override those
of the Conceptual Framework.
Principles established in the Conceptual Framework

There are two important assumptions that form the foundation of general purpose financial
reporting. These are the assumption of the accrual basis of accounting and the assumption that
the entity is a going concern.
Accrual basis
The accrual basis of accounting recognises the effects of transactions and other events when they
occur (which may not correspond to the time that cash is exchanged in response to a transaction)
and reports them in the financial statements in the periods to which they relate.
The accrual basis of accounting requires an entity to recognise expenses when they are incurred
rather than when cash is paid. For example, an entity recognising revenue from selling goods or
services on credit recognises the related expenses (cost of goods sold) incurred in earning that
revenue, regardless of when the cash outflow relating to those expenses takes place. The accrual
basis requires an entity to recognise the depreciation of a non-current asset (with a limited useful
life) as the economic benefits of that asset are consumed or expire; an entity does not account
for the asset as an expense in the period in which it is acquired.
The accrual basis is used on the assumption that it provides a better basis for assessing the
entity’s past performance and predicting future performance than relying only on financial
statements prepared on a cash basis (Conceptual Framework, para. OB17).
If you wish to explore this topic further, read paras OB17–OB19 of the Conceptual Framework.
Study guide | 27
➤➤Question 1.4
In its first year of operations, Tower Ltd purchased and paid for widgets costing $50 000.
During that year, Tower Ltd sold 60 per cent of the widgets. The widgets on hand at the end of
the year cost $20 000. The sales were on credit terms. Tower Ltd received $37 000 in cash from
customers, and $3000 remained uncollected at the end of the year. During the last quarter of the
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first year of operations, Tower Ltd entered into a property insurance contract for losses arising
from fire or theft. The annual premium of $4000 was paid in cash and the insurance expired nine
months after the end of the reporting period.
Calculate Tower Ltd’s profit for the first year of operations on an accrual basis and on a cash basis.
Explain the difference between the two measures. Which of the two profit measures is more
useful for assessing Tower Ltd’s performance during its first year of operations? Give reasons
for your answer.
Going concern
Financial statements prepared in accordance with the going concern assumption presume
that the entity will continue to operate for the foreseeable future. The carrying amount of
assets and liabilities in the statement of financial position are normally based on the going
concern assumption. For example, the carrying amount of property, plant and equipment—
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whether measured on a cost or fair value basis—assumes that the carrying amount will be
recoverable through the entity’s continuing operations. Some assets, such as property and
plant, may be stated at amounts that exceed their disposal value because the entity expects
to obtain greater economic benefits through the continued use of such an asset.
Where the going concern assumption is not appropriate (e.g. because of the entity’s intention or
need to wind up operations), the financial statements should be prepared on some other basis.
The Conceptual Framework does not specify an alternative basis. However, one approach may
be to state assets at their net realisable value—which in the case of certain intangible assets
may be negligible—and liabilities at the amount required for their immediate settlement.
If you wish to explore this topic further, read para. 4.1 of the Conceptual Framework.
Qualitative characteristics of useful

financial information
Chapter 3 of the Conceptual Framework focuses on qualitative characteristics. To be useful,
financial information must:
be relevant and faithfully represent what it purports to represent. The usefulness of
financial information is enhanced if it is comparable, verifiable, timely and understandable
(Conceptual Framework, para. QC4).
This is illustrated in Figure 1.3.
Figure 1.3: Qualitative characteristics of financial information
Relevance
Fundamental
qualitative
characteristics Faithful
representation
Comparability
Verifiability
Enhancing
qualitative
characteristics
Timeliness
Understandability

Study guide | 29
Fundamental qualitative characteristics

Relevance
Information is relevant when it is capable of influencing the decisions of users (Conceptual
Framework, para. QC6). This influence can occur through the predictive value or the confirmatory
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value of financial information, or both. Table 1.5 shows how relevant information helps users.
Table 1.5: How relevant information helps users
The Conceptual Framework

requires relevant information How this relates to
that helps users … financial reporting An example
… in forming expectations This relates to the Financial information can be used to predict
about the outcomes of past, predictive value of the future cash flows of an entity and the
present and future events financial information timing and uncertainty of those cash flows.
… in confirming or correcting This is referred to Expectations of future cash flows can be

their past evaluations as feedback, or the compared with actual cash flows when
confirmatory value of financial statements relating to those future
financial information periods are issued and the reasons for any
differences between expected cash flows
and actual cash flows are investigated.
Materiality
Relevance also encompasses materiality. A subjective approach to materiality is adopted in the
Conceptual Framework:
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 (Conceptual Framework, para. QC11).
Materiality is an aspect of relevance that can be affected by the nature or the size of an item
of financial information, or both. Quantitative thresholds for materiality are not used in the
Conceptual Framework because the application of the concept of materiality is entity-specific
(Conceptual Framework, para. QC11). Consider the following examples:
• An entity may engage in transactions with its directors that involve amounts that are not
material to the entity. However, the disclosure of these related party transactions may be
relevant to users’ needs, irrespective of the amounts involved, because of the nature of the
relationship between the directors and the entity and their accountability to shareholders.
• An entity may engage in new activities, the results of which have little impact on profit
at present. However, the results may be relevant to the decision-making needs of users
because they may affect the users’ assessment of the entity’s risk profile.
Whether information is material is a matter of judgment that depends on the facts and
circumstances of an entity. The IASB released a draft Practice Statement in 2015 that highlighted
some ways in which management can identify whether financial information is useful to the
primary users, outlined in Table 1.6.
Table 1.6: Identifying financial information useful to users of financial reports
Consideration Example
User expectations How users think the entity should be managed (i.e. stewardship) gathered
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through discussions with users or from information that is publicly available
Management perspective Changing management perspective to think about decisions from the
perspective of the user (i.e. as if they were external users themselves and
did not have the internal knowledge held by management, for example,
about key risks or key value drivers)
Observing user or market For example, on particular transactions or disclosures issued by the entity
responses to information or on responses by external parties such as analysts
Observing industry peers For example, observing what information peers within the industry are
presenting in their financial reports (Although there are similarities between
entities in the same industry, it does not mean that the same kind of
information will necessarily be material.)
Source: Adapted from IFRS Foundation 2015, IFRS Practice Statement: Application of Materiality
to Financial Statements, Exposure Draft ED/2015/8, para. 22, pp. 13–14, accessed November 2017,
http://archive.ifrs.org/Current-Projects/IASB-Projects/Disclosure-Initiative/Materiality/Exposure-Draft-
October-2015/Documents/ED_IFRSPracticeStatement_OCT2015_WEBSITE.pdf.
If you wish to explore this topic further, read paras QC4–QC11 of the Conceptual Framework.
Faithful representation
Together with relevance, faithful representation is a fundamental qualitative characteristic of
useful financial information.
Faithful representation requires that financial information faithfully represent the transactions
and events that they purport to represent (Conceptual Framework, para. QC12). For example,
the statement of financial position should faithfully represent the events that give rise to assets,
liabilities and equity at the end of the reporting period. Ideally, faithful representation means that
financial information is complete, neutral and free from error. However, it is usually impractical to
maximise these three characteristics simultaneously.
Faithful representation implies that there should be a fair representation of economic outcomes.
However, this assumes that there are accounting solutions to all of the problems and financial
reporting issues encountered by preparers of the financial reports. In practice, difficulties in
identifying the transactions and other events that must be accounted for, as well as in applying
or developing appropriate measurement and presentation techniques, can impede the
achievement of faithful representation.
Application of fundamental qualitative characteristics

For information to be useful, it must be both relevant and faithfully represented. This may involve
professional judgment in making a trade-off between relevance and faithful representation.
For example, information about future cash flows expected to be derived from an asset may
be highly relevant, but it may be difficult to faithfully represent this aspect of the asset because
of the inherent uncertainty of future events. Paragraph QC18 of the Conceptual Framework
suggests a process for making such judgments.
Study guide | 31
➤➤Question 1.5
Coalite Ltd participates in an emissions trading scheme. It holds emission trading allowances,
which provide a permit for a specified amount of carbon emissions for the year. If its operating
processes result in carbon emissions, Coalite Ltd must deliver sufficient emission trading
allowances to the government to ‘pay’ for the amount of carbon emitted during the year. If it
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does not hold enough emission trading allowances, Coalite Ltd will need to buy more to settle
its obligation to the government. If the company’s holding of trading allowances is surplus to its
needs, the allowances may be sold.
Assume that in determining how to apply the fundamental qualitative characteristics, the chief
financial officer (CFO) of Coalite Ltd has completed the first step by identifying the emission trading
allowances held as being potentially useful to the users of the company’s financial statements.
(a) Identify the type of information about emission trading allowances that would be most
relevant if it were available and could be faithfully represented.
(b) Do you think the information that you suggested is likely to be available and able to be
represented faithfully? If not, what might be the next most relevant type of information
about the emission trading allowances?
Enhancing qualitative characteristics

Comparability
Comparability is one of the four enhancing qualitative characteristics. Financial information is
more useful if it can be compared with similar information about other entities and with similar
information about the same entity for another reporting period. The ability to compare financial
statements over time is important to enable users to identify trends in the entity’s financial
position and performance. The ability to compare the financial statements of different entities
is important in assessing their relative financial position and performance.
Comparability also enables users to recognise similarities or differences between two sets of
economic phenomena. For example, an entity with an existing investment in Company A is
deciding whether to continue to invest in Company A or to move its investment to Company B.
Comparable financial information will help the investor in making the decision.
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The Conceptual Framework refers to the concept of consistency, which is defined as ‘the use
of the same methods for the same items’ (para. QC22). This may be in reference to the use
of consistent methods either by different entities for the same period or by the same entity
over different periods. Consistency of accounting methods is seen as contributing to the goal
of comparability.
Comparability is not satisfied by mere uniformity of accounting policies and methods. In fact,
the Conceptual Framework (para. QC23) cautions against this view because it may result in
dissimilar information appearing to be alike. For example, assets that form part of continuing
operations differ from assets that form part of discontinued operations. Future economic benefits
of assets that form part of continuing operations are expected to be recovered by the use and
disposal of those assets in the ordinary course of business. The future economic benefits of
assets forming part of discontinued operations are expected to be recovered principally through
sale rather than continued use. The adoption of consistent accounting methods to represent
economic information about assets that form part of continuing operations and those that form
part of discontinued operations would not enhance comparability. Such methods would fail to
reflect the differences in the way that economic benefits are expected to be derived from the
two types of assets.
Comparability of financial statements is enhanced by the disclosure of the accounting policies

adopted in preparing the financial statements and of any changes in those policies and their
effects. Disclosure of accounting policies is considered further in Module 2.
Verifiability
Verifiability exists if knowledgeable and independent observers can reach a consensus that the
information is faithfully represented. As shown in Table 1.7, verification may be direct or indirect.
Table 1.7: Form of verification
Form of verification Example
Direct Confirming the market price used to measure the fair value of an asset that
is traded in an active market
Indirect Checking the inputs and processes used to determine the reported
information. For example, verifying fair value with a model that checks
inputs such as the contractual cash flows and the choice of an appropriate
interest rate, and the methodology or rationale used to estimate fair value.
Consensus might refer to a range (e.g. an estimate of the fair value of a

corporate bond that is not traded in an active market as being between
$940 and $970) but not necessarily to a point estimate (e.g. the historical
cost being $990). Verifiability can help to assure users that financial
information is faithfully represented.
para. QC27, in 2017 IFRS Standards, IFRS Foundation, London, p. A36. © CPA Australia 2017.
Study guide | 33
Timeliness
Timeliness enhances the relevance of information in GPFSs. Undue delays in reporting information
may reduce the relevance of that information to users’ decision-making.
The timeliness of financial information is critical for investment decisions. Unexpected surprises
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and delayed news that impacts negatively on the financial statements will normally result in a loss
of confidence and plummeting share prices within the investment market.
To maintain the timeliness of information reported in financial statements, it may be necessary

to report on the effects of a transaction or other event before all of the required information is
available. Accordingly, it may be necessary to use estimates instead of waiting until more directly
observable information becomes available.
Understandability
Understandability requires the information in financial statements to be clearly and concisely
classified, characterised and presented (Conceptual Framework, para. QC30).
Understandability cannot be interpreted independently of the capability of users of the financial

statements. Users are presumed to have reasonable knowledge of business and economic
activities (Conceptual Framework, para. QC32). This implies that the informed user should
readily understand the measurement attribute adopted for a particular financial statement item.
Information is not excluded from a financial report merely because it is difficult for users to
understand (Conceptual Framework, para. QC31). This would be inconsistent with the
characteristic of completeness incorporated in faithful representation.
➤➤Question 1.6
The objectives of IFRS 13 Fair Value Measurement include establishing a common definition of fair
value and common guidance for fair value measurement. The standard prescribes the following
fair value measurement hierarchy (in descending order):
Level 1 Quoted price for an identical asset or liability
Level 2 Model with no significant unobservable inputs
Level 3 Model with significant unobservable inputs.
Explain how the enhancing qualitative characteristics, comparability and verifiability, are applied
in the requirements of IFRS 13.
Application of enhancing qualitative characteristics

Although enhancing characteristics improve the relevance or faithful representation of information,
they do not make irrelevant or unfaithfully represented information useful. If information were
omitted from financial statements, rendering them incomplete (not faithfully represented),
the consistent omission of that information over multiple periods may provide comparability,
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but it would not make the information useful. For example, if an entity omitted several material
subsidiaries from its consolidated financial statements, repeating this omission in each reporting
period may provide comparability. However, financial statements that do not faithfully represent
the financial position and financial performance of the group that they report on are not useful for
user decision-making.
Preparers need to exercise professional judgment in balancing the qualitative characteristics

and in assessing the relative importance of enhancing characteristics in different contexts.
In selecting an appropriate accounting policy, such as a measurement attribute, preparers
may need to make a trade-off between an enhancing qualitative characteristic and another
qualitative characteristic. For instance, the preparer may need to forego the enhancing
qualitative characteristic of comparability to change an accounting policy in the interests
of providing more relevant or more faithfully represented information.
For example, an entity may adopt fair value measurement in order to provide more relevant
information at the expense of comparability with previous periods. Additional disclosures,
such as the reason for and effects of the change of accounting policy, and the restatement of
reported comparative amounts may improve comparability to assist users in making decisions
about the particular entity.
Module 2 considers the application of comparability in IAS 8 Accounting Policies, Changes in

Accounting Estimates and Errors in the context of disclosure requirements for changes
in accounting policies.
The cost constraint on useful financial reporting

The Conceptual Framework (para. QC35) notes that a pervasive constraint on financial reporting
is the balance between the costs of providing financial information versus the benefits derived
from such information. The costs of collecting, processing, verifying and disseminating financial
information fall mainly on the entities responsible for preparing financial reports. The users of
financial reports also incur costs to analyse and interpret the information. If useful information
is not provided, users may make estimates or, where possible, incur additional costs to obtain it
from other sources.
Providing useful financial information also facilitates the efficient functioning of capital markets
and lowers the cost of capital (Conceptual Framework, para. QC37). The provision of relevant and
faithfully represented financial information enables users to make more informed decisions and
to make their decisions more confidently. However, even if it were possible, the cost of meeting
all information needs of all users would be prohibitive. Materiality plays an important role in
helping preparers and users of financial reports decide what information needs to be provided.
In addition, the IASB provides specific exemptions within standards. For example, a lessee may
elect to not apply lease recognition, measurement and presentation requirements to leases
of less than 12 months and where the asset being leased is of low value (IFRS 16, paras 5–8).
This exemption is allowed because the cost of obtaining the required information may exceed
the benefit of providing the information to users.
Study guide | 35
Application of qualitative characteristics in the International

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

Now that the fundamentals of financial reporting have been discussed, how the Conceptual
Framework addresses the elements that make up the financial statements will be considered.
The elements of financial statements are assets, liabilities, equity, income and expenses.
Figure 1.4 presents the key decisions relating to the elements of the financial statements.
The first two decisions (definition and recognition) will be discussed in this section,
while measurement will be considered later in the module.
Note: The 2010 version of the Conceptual Framework does not address disclosure. However,
there is a proposal to include disclosure in the revised Conceptual Framework.
Figure 1.4: Key decision areas in accounting for transactions and other events
• Did a past event, or events, give rise to an item that satisfies

1. Definition
the definition of an element of financial statements?
• Does an item that meets the definition of an element need to be

2. Recognition
incorporated in the financial statements?
• How to measure the items that are recognised in financial

3. Measurement
statements?
• How should items be disclosed or presented in the financial

4. Disclosure/Presentation
statements or notes to the accounts?

Defining the elements of financial statements

Assets
Note that the definitions of assets and liabilities are fundamental because the definitions of
the other elements flow from them. The Conceptual Framework defines an asset as:
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a resource controlled by the entity as a result of past events and from which future economic
benefits are expected to flow to the entity (Conceptual Framework, para. 4.4(a)).
The three key components of the asset definition are:

1. the requirement for the entity to have control of the asset
2. that a past event has occurred
3. future economic benefits are expected to flow to the entity.
It is important to note that the definition does not require the asset to be a physical asset.
Many assets, such as patents and copyrights, are intangible in nature. These assets give rise
to future economic benefits (in the form of royalties or sales) but do not have a physical form.
For an entity to have control, it does not necessarily follow that the entity has ownership of the
asset. For example, IFRS 16 Leases requires a right-of-use asset to be recognised for a leased asset,
even though the entity does not own the underlying asset (e.g. a building). This is because the
entity controls the benefits arising from using the asset during the lease term.
A past event normally occurs when the asset is purchased or produced (Conceptual Framework,
para. 4.13). However, assets may also arise in other circumstances. For example, an asset may
be gifted to the entity as part of a government grant program. It is important to draw the
distinction between past events and transactions or events that are expected to occur in the
future. Future transactions do not give rise to assets until such time as they occur. For instance,
if an entity develops an operational plan that requires the purchase of an item of machinery
in six months, the definition of an asset is not met until such time as the machinery is purchased.
Consider the following example. A mining company has responsibility for maintaining a private
road on land over which it holds a lease. The road provides access to the mine. Recently,
the company paid for the road to be resealed (resurfaced) at a cost of $3 million. The economic
benefits from the resealed road are expected to be obtained over several accounting periods,
but the association with income can only be broadly or indirectly determined.
In accordance with IAS 16 Property, Plant and Equipment, the expenditure on resealing the road
should be capitalised as part of the road. The new seal enhances the economic benefits that
the company expects to obtain from the use of the road. Control has been established because
the resealed road is on land over which the company has obtained control by entering into a
lease. The costs of resealing the road should then be recognised as expenses (i.e. depreciation)
progressively over the useful life of the road.
Liabilities
A liability is defined as:
a present obligation of the entity arising from past events, the settlement of which is
expected to result in an outflow from the entity of resources embodying economic benefits
(Conceptual Framework, para. 4.4(b)).
The key components of the liability definition are:

1. the requirement for the entity to have a present obligation
2. that a past event has occurred
3. an outflow of future economic benefits is expected.
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A present obligation may be legally enforceable, or it may arise from normal business practice,
custom and a desire to maintain good business relationships or to act in an equitable manner.
For example, an entity selling goods may choose to accept the return of faulty goods for a
full exchange, even after the contractual warranty period has expired, to maintain favourable
relationships with its customers. It is important to note that a decision by management
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to undertake a particular transaction in the future (e.g. to acquire a new item of plant and
equipment) does not, of itself, give rise to a present obligation (Conceptual Framework, 4.16).
Liabilities only arise from a past event or transaction. For example, if an entity purchases an item
of equipment for $1 million and agrees to pay for the equipment in 90 days, the past event is
purchasing the asset (the equipment), and the entity has an obligation to pay for the equipment.
The outflow of resources embodying economic benefits (i.e. an outflow of assets) is often
referred to as the ‘settlement’ of a liability. Paragraph 4.17 of the Conceptual Framework
provides examples of how a liability might be settled, as shown in Figure 1.5.
Figure 1.5: Examples of how a liability might be settled
Transfer of
other assets
Payment Liability Provision

of cash settlement of services
Replacement of
Conversion of
the obligation
the obligation
with another
to equity
obligation
para. 4.17, in 2017 IFRS Standards, IFRS Foundation, London, p. A43. © CPA Australia 2016.
The replacement of an obligation with another obligation and the conversion of an obligation to
equity do not directly involve an outflow of resources embodying economic benefits. Consider,
for example, the issue of shares to debt-holders in settlement of a liability. The issue of shares
would normally involve consideration passing to the entity. If debt is settled by conversion
to shares, the consideration ‘paid’ by the debt-holders is the surrender of their debt claim
against the entity. From the perspective of the entity issuing the shares, the consideration is the
discharge of the obligation for the debt. Instead of receiving an inflow of assets in consideration
for the issue of shares, it has avoided an outflow of assets. The economic substance is the same
as if the new shareholders had contributed cash or other assets for the shares and those assets
were used to settle the liability.
Equity
Equity is defined as ‘the residual interest in the assets of the entity after deducting all its
liabilities’ (Conceptual Framework, para. 4.4(c)).
The definition of equity flows from the definitions of assets and liabilities. Equity is simply the
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difference between assets and liabilities. Furthermore, the amount at which equity is shown in
the statement of financial position is derived from the recognition and measurement of assets
and liabilities.
If you wish to explore this topic further, read paras 4.2–4.23 of the Conceptual Framework.
Income
Income is defined as:
increases in economic benefits during the accounting period in the form of inflows or
enhancements of assets or decreases of liabilities that result in increases in equity, other than
those relating to contributions from equity participants (Conceptual Framework, para. 4.25(a)).
The two essential characteristic of income are:

1. an increase in assets or a reduction in liabilities
2. an increase in equity, other than as a result of a contribution from owners.
Income does not arise from an increase in assets if there is a corresponding increase in liabilities
because there would not be an increase in equity. For example, if an entity receives revenue
in advance of services being provided, it would recognise an increase in assets (i.e. cash) and
an equivalent increase in liabilities (i.e. unearned revenue or revenue received in advance)
representing services yet to be rendered. Income does not arise until the liability is reduced.
As the services are rendered, the entity recognises income and a corresponding reduction in
the liability.
Income refers to both revenue and gains. Revenue arises in the course of the ordinary activities
of an entity (e.g. through sales). Revenue from contracts with customers, a subset of revenue,
is discussed in Module 3. Gains are those items that meet the definition of income that may or
may not arise in the course of ordinary activities of an entity (e.g. sale of a non-current asset).
They are not a separate element in the Conceptual Framework as they are not considered
different in nature to revenue (Conceptual Framework, para. 4.30).
Expenses
Expenses are defined as:
decreases in economic benefits during the accounting period in the form of outflows or depletions
of assets or incurrences of liabilities that result in decreases in equity, other than those relating to
distributions to equity participants (Conceptual Framework, para. 4.25(b)).
The two essential characteristics of an expense are:

1. a decrease in economic benefits that may arise through outflows or depletions of assets
or an increase in a liability
2. a decrease in equity, other than those arising from distributions to equity participants.
An expense is the opposite of income. An example of an expense is wages, which involve

outflows of cash and cash equivalents to employees for the provision of services. Depreciation
is an example of an expense involving the depletion of assets. The accrual of electricity charges
gives rise to an expense involving the incurrence of a liability.
Study guide | 39
Under the IFRSs, not all items that meet the definition of income and expenses are recognised
in profit. For example, revaluation gains on property, plant and equipment under the valuation
model are required to be recognised in OCI and accumulated in equity, unless a prior downward
revaluation is being reversed (IAS 16 Property, Plant and Equipment). Gains and losses that are
recognised in other comprehensive income are reported in the P&L and OCI in accordance with
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IAS 1 Presentation of Financial Statements (refer to Module 2).
Criteria for recognising elements of financial statements

An item that meets the definition of an element of financial statements should be recognised if:
(a) it is probable that any future economic benefit associated with the item will flow to or from
the entity; and
(b) the item has a cost or value that can be measured with reliability (Conceptual Framework,
para. 4.38).
The first recognition criterion relates to probability, which is not defined or clarified in the
Conceptual Framework. However, there is a statement that probability refers to the degree of
uncertainty associated with the flow of future economic benefits to or from the entity (para. 4.40).
‘Probable’ is often interpreted in the mathematical sense of having a likelihood of occurrence
greater than 0.5 and is defined in IFRS 5 Non-current Assets Held for Sale and Discontinued
Operations as being ‘more likely than not’.
The second recognition criterion is that the item has a cost or value that can be measured
with reliability. This is not to say that the cost or value must be known or be directly observable.
The Conceptual Framework states: ‘the use of reasonable estimates is an essential part of
the preparation of financial statements and does not undermine their reliability’ (para. 4.41).
Determining a reasonable estimate is subjective and may require professional judgment.
Items that do not meet the probability criterion or the reliable measurement criterion
(but otherwise meet the definition), such as contingent liabilities, may warrant disclosure in
the notes to the financial statements (covered in Module 3).
The recognition of income occurs:

when an increase in future economic benefits related to an increase in an asset or a decrease
of a liability has arisen that can be measured reliably (Conceptual Framework, para. 4.47).
When income is recognised, there is a corresponding increase in assets, such as an increase

in accounts receivable, or a decrease in liabilities, such as a reduction in a liability for
unearned revenue.
The recognition of expenses occurs:

when a decrease in future economic benefits related to a decrease in an asset or an increase of a
liability has arisen that can be measured reliably (Conceptual Framework, para. 4.49).
The Conceptual Framework notes that the recognition of expenses is simultaneous with the
recognition of a reduction in an asset or the increase in a liability. For example, the recognition
of a cost of goods sold expense coincides with a reduction in the amount recognised as an asset
for inventory.
As noted earlier, the definitions and recognition criteria for assets, liabilities, income and
expenses set out in the Conceptual Framework are referenced in IAS 1, para. 15.
If you wish to explore this topic further, read paras 15–24 of IAS 1 Presentation of Financial Statements.
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Constraints on frameworks
The business and legal environments in which entities operate, and the social and political
environment within which standard setting occurs, may impose limitations on some of the
claimed benefits of a conceptual framework. Although a framework may establish principles,
it does not necessarily remove the need for professional judgment by accountants.
For technical reasons, it may not always be possible to have conceptual consistency between
accounting standards, but inconsistency may also arise because of the need to take economic
constraints or consequences into consideration. The application of accounting standards can
have economic consequences that management and user groups consider disadvantageous.
For example, an accounting standard might prohibit the recognition of certain intangible
assets, or it might reduce the incidence of their recognition by requiring that very stringent
conditions be satisfied before such assets are recognised. Applying such an accounting standard
could reduce the reported profit of some entities and increase the volatility of the reported
profit of others. In turn, this could cause share prices of the affected entities to fall because
of investors’ perceptions that the risk of investing in such entities has increased. Moreover,
if managers’ salaries are based (even in part) on share prices, their remuneration may decrease.
Economic consequences of this kind may lead to accounting standard setters departing from
a conceptually ‘pure’ approach outlined in a framework in order to satisfy interest groups who
claim that their interests would otherwise be adversely affected.
Other types of constraints include social and political constraints. These may arise because
professional accountants feel that their ability to exercise autonomy and judgment is constrained
by the Framework and related standards. Political constraints may arise as external regulators
seek to impose their own desires on how reporting is performed.
A final constraint is based on human resources and cost. A considerable amount of time and cost
is required to create and apply the framework, and it is necessary to work with a wide range of
stakeholders. Lack of funding and time is often a constraint in this regard.
Measurement of elements of financial statements

After it has been determined that an event has resulted in an item that meets the definition
of an element of financial statements (item 1 of Figure 1.4) and that the recognition criteria
are satisfied (item 2 of Figure 1.4), the next decision is in relation to how the item should be
measured (item 3 of Figure 1.4).
In relation to assets and liabilities, there are two stages of the measurement decision:
1. how to measure the asset or liability at initial recognition
2. how to measure the asset or liability subsequent to initial recognition.
Study guide | 41
Changes in assets and liabilities affect the reported income, expenses and equity. Therefore,
the measurement attributes chosen for assets and liabilities have clear implications for the
amount of income and expenses reported in financial statements.
In accounting, the properties, or attributes, of elements of financial statements—as distinct
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from the elements themselves—are measured. However, the distinction between measuring
the attributes of financial statement items and their definitions and recognition criteria is not
clear-cut. The probability that future economic benefits will flow to or from the entity is one
of the recognition criteria used in the Conceptual Framework. However, the probability of the
flow of future economic benefits may also affect the measurement of the elements of financial
statements. For example, the uncertainty of the flow of future economic benefits is reflected in
the use of a risk-adjusted discount rate in calculating the present value (PV) of future cash flows.
Further, accounting measurement is problematic because various attributes of a particular

element can be measured in the same unit of measurement. For example, the value in use
of an asset (an entity-specific value) or its value in exchange can be measured using the same
currency unit.
Different bases can be adopted in measuring the same attribute. For example, the value in
exchange of an asset may be measured at market price or at net realisable value.
The Conceptual Framework merely defines measurement and identifies alternative measurement
bases, before concluding with a description of practice. It fails to provide concepts or principles
to guide the selection of appropriate measurement bases. However, accounting standards
may state the measurement basis for a specific event; for example, IAS 2 Inventory states the
measurement basis for inventory at cost or net realisable value, whichever is lower.
Cost-based and value-based measures used in the International Financial

Reporting Standards
In broad terms, cost-based measures in relation to assets include measures of the cost incurred
by an entity to acquire an asset. Cost-based measures of assets are based on entry prices.
An entry price is the price paid to acquire an asset or received to assume a liability (IFRS 13,
para. 57).
In relation to a liability, cost-based measures include the proceeds received in exchange for
the obligation, such as the proceeds of an issue of debentures, or the amounts of cash or
cash equivalents expected to be paid to satisfy the liability in the normal course of business
(e.g. provision for annual leave).
Variations of cost-based measures may adjust the cost for amortisation, depreciation or
interest expense, as well as for any accumulated impairment.
Value-based measures broadly include those measurement attributes that require some
form of valuation to be undertaken, such as fair value. In practice, the distinction between
cost‑based and value-based measures may have more to do with semantics than with substance.
For example, to measure the cost of acquiring an asset, it is necessary to measure the fair value
of the purchase consideration. Figure 1.6 depicts the key cost-based and value-based measures
used in IASB pronouncements. The key characteristics of the measures applied in the IFRSs
are also described.
Figure 1.6: M
easurement bases specified under International Accounting
Standards Board pronouncements
Measurement bases under IASB pronouncements

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Cost-based Value-based
Cost/historical cost Fair value
Amortised cost Current cost
Fair value less costs of disposal
Net realisable value
Present value
(measurement technique) Realisable (settlement) value
Value in use
Cost/historical cost
The first cost-based measure shown in Figure 1.6 is cost/historical cost. The Conceptual
Framework uses the term ‘historical cost’ to refer to the same concept described as ‘cost’ in
various IFRSs. The definition of ‘historical cost’ in the Conceptual Framework (para. 4.55(a)) is:
the amount of cash or cash equivalents paid or the fair value of the consideration given to acquire
them at the time of their acquisition.
This definition is similar to the definition of cost used in a number of IASB pronouncements—
for example IAS 16 Property, Plant and Equipment, para. 6:
The amount of cash or cash equivalents paid or the fair value of the other consideration given to
acquire an asset at the time of its acquisition or construction or, where applicable, the amount
attributed to that asset when initially recognised in accordance with the specific requirements of
other IFRSs.
However, the Conceptual Framework extends its use of the concept of historical cost to liabilities,
noting that under historical cost:
liabilities are recorded at the amount of proceeds received in exchange for the obligation, or in
some circumstances (e.g. income taxes), at the amounts of cash or cash equivalents expected to be
paid to satisfy the liability in the normal course of business (para. 4.55(a)).
Study guide | 43
Paragraph 4.56 of the Conceptual Framework notes that historical cost is the measurement
basis most commonly adopted by entities in preparing their financial statements. While cost,
or historical cost, is often applied to many classes of assets, such as property, plant and
equipment and most intangible assets, other measurement bases are also in common use.
Present practice is best described as a mixed measurement accounting model.
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The following advantages have been claimed for the historical cost basis of accounting:
• Easily understood—by users and preparers of financial statements.
• Relevant to decision-making—as it is the value of the consideration given or received in
exchange for an asset or a liability.
• Reliable—historical cost provides evidence for income based on actual transactions with
external parties.
• Inexpensive to implement—the measurement of historical cost is linked to the occurrence
of transactions and is therefore readily available at little or no additional cost.
The following deficiencies have been attributed to the historical cost basis of accounting:
• Limited relevance to decision-making
–– Historical cost is merely a historical record of the sacrifice, not a forward-looking measure.
Therefore, it has limited predictive value.
–– Historical cost results in the distortion of performance measurement caused by old costs
being associated with current revenues. Some critics argue that it is better to match the
benefit received against the cost expended to replace the asset.
–– Under historical cost, profits are recognised when realised (i.e. when a transaction occurs),
not when the prices or other values of assets and liabilities change. Therefore, profit can
be affected by the selective timing of the sale of assets.
–– Historical cost must be supplemented by additional rules that check to see whether the
amount is recoverable. This is necessary to ensure that the carrying amount of the asset
(i.e. the amount at which it is recognised in the statement of financial position) does not
exceed the future economic benefits that the entity expects to derive from the asset.
By contrast, market value reflects the market’s assessment of the recoverable amount
of an asset.
–– Historical cost does not satisfactorily deal with assets acquired for nil or
nominal consideration.
• Undermines the comparability of financial reports

–– Costs incurred at various points in time are aggregated as though they are equivalent
in economic terms.
–– In the case of self-constructed assets, the costs incurred depend on the efficiency of
the entity. For example, if two companies were building identical assets, the less efficient
of the two would incur the higher costs. Users may conclude that the company with the
higher cost base is superior to the company that incurred the lesser costs to construct
the asset.
• Problems with reliability

–– There can be difficulties in objectively determining the historical cost when calculating
the fair value of the purchase consideration and other incidental costs.
–– Historical cost reflects, at a minimum, management expectations of the recoverability
of an asset, rather than market expectations.
–– The historical cost of some items may have resulted from an arbitrary allocation of an
overall cost to assets, liabilities and expenses, for example, allocating overhead costs
across items of inventory. These allocations may be arbitrary and may undermine the
representational faithfulness of historical cost.
➤➤Question 1.7
The Sydney Harbour Bridge was officially opened on 19 March 1932. The total cost of the bridge
was approximately 6.25 million Australian pounds ($13.5 million) and was eventually paid off in
1988 (Sydney Online 2014).
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Explain some of the limitations of using historical cost for the subsequent measurement of the
Sydney Harbour Bridge.
Amortised cost
The second cost-based measure depicted in Figure 1.6 is amortised cost. This is a measure
applied to certain financial assets and financial liabilities subsequent to initial recognition.
Amortised cost is defined in IFRS 9 Financial Instruments as:
the amount at which the financial asset or financial liability is measured at initial recognition minus
the principal repayments, plus or minus the cumulative amortisation using the effective interest
method of any difference between that initial amount and the maturity amount, and, for financial
assets, adjusted for any loss allowance (IFRS 9, Appendix A).
Amortised cost is calculated using the effective interest method. This method uses the effective
interest rate to allocate interest income and interest expense over the effective life of a financial
asset or liability. The effective interest rate is the rate that discounts the estimated future cash
payments or receipts through the expected life of a financial asset or liability to the net carrying
amount of the financial asset or liability.
Study guide | 45
Example 1.3: Amortised cost

B Ltd issues a note payable with the following terms:
• face amount (i.e. maturity value) of $100
• repayable at the end of Year 2
• coupon interest at the rate of 10 per cent per period (year), which is payable at the end of each year.
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The issuer of the note is obligated to pay $10 interest at the end of Year 1 (t1) and $110, being interest
and principal, at the end of Year 2 (t2). It is common for debt securities to be issued at an amount
other than face value.
The cash outflows are illustrated in Figure 1.7.
Figure 1.7: Cash outflows arising from issue of financial liability

$10 $110
($100 × 0.10) ($100 × 0.10 + $100)
t0 t1 t2
If the market expects a rate of return greater than 10 per cent for a debt security of equivalent risk,
the issuer will need to discount the issue price so that the holder effectively earns the expected rate
of return.
Example 1.4: Effective interest rate

Some of the facts from the previous example have been changed.
B Ltd issues a note payable with the following terms:

• proceeds received on issue $96.62
• maturity value of $100
• repayable at the end of Year 2
• coupon interest at the rate of 10 per cent per period (year), which is payable at the end of each year.
The issuer of the note is still obligated to pay $10 interest at the end of Year 1 (t1) and $110, being interest
and principal, at the end of Year 2 (t2).
However, based on the consideration received, the market rate of interest (i.e. the effective interest
rate) demanded by purchasers of the debt security was 12 per cent. The effective interest rate is the
rate at which the PV of the contractual cash flows over the life of the debt security equals the initial
carrying amount of $96.62.
The PV can be calculated by using PV tables available in many financial accounting, management
accounting and finance texts. PV tables provide discount factors for the calculation of the PV of $1
paid in n periods, for a given interest rate, r. For example, the discount factor for the PV of $1 paid one
period (one year) from now, given an interest rate of 12 per cent per period (p.a.), is 0.89286. The PV
of $1 paid one year from now, assuming an interest rate of 12 per cent, is $0.89286.
The following table provides selected extracts from PV tables.

PV (discount) factors
Number of period (n) PV factor (r = 12%)
1. 0.89286
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2. 0.79719
Based on the PV factors, the PV of the cash flows shown in this example, given an interest rate of
12 per cent per annum, can be calculated as follows:
$
PV of $10 received at t1 = $10 × 0.89286 = 8.93
PV of $110, received at t2 = $110 × 0.79719 = 87.69
96.62
Alternatively, the tables for the PV of an annuity may be used. In this case, the cash flows are viewed
as two streams of cash flows: an annuity of $10 per annum for two years, payable in arrears; and a
payment of $100 at the end of two years. The discount factor to calculate the PV of an annuity for
two periods, given an interest rate of 12 per cent, is 1.69005. The PV of the cash flows shown in this
example, given an interest rate of 12 per cent per annum, can then be calculated as follows.
$
PV of an annuity of $10 p.a. for two years = $10 × 1.69005 = 16.90
PV of $100, received at t2 = $100 × 0.79719 = 79.72
96.62
Example 1.5: Amortised cost at reporting date

Continuing to use the information from the previous examples, now consider amortised cost at
reporting date.
The note is carried by the issuer at amortised cost.
At t1, when discounted at the effective rate of interest, the PV of the remaining cash flows is $98.21
($110 / 1.12). The discounting procedure automatically takes into account any principal repayments
that have been made (at t1, no principal repayments have occurred in relation to the debt security) and
any cumulative amortisation of the initial discount on issue, as required by the definition of amortised
cost in IFRS 9 Financial Instruments.
This is illustrated by the calculation for the period ended t1 in the following table.
Amortisation schedule
Unamortised
Coupon Effective Discount discount Carrying
interest interest amortised balance amount
Date (10%) (12%) $ $ $
t0 3.38(a) 96.62
t1 10.00(b) 11.59(c) 1.59(d) 1.79(e) 98.21(f)
t2 10.00(b) 11.79(g) 1.79(h) 100.00(i)
Total 20.00 23.38 3.38
(a) $100.00 − $96.62 (f) $96.62 + $1.59 = $100.00 − $1.79

(b) $100.00 × 0.10 (g) $98.21 × 0.12
(c) $96.62 × 0.12 (h) $11.79 − $10.00
(d) $11.59 − $10.00 (i) Before principal repayment
(e) $3.38 − $1.59
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At the date of issue, the PV of the debt security at a discount rate of 12 per cent was $96.62.
The unamortised discount at t0 was the difference between the maturity value of the debt, $100,
and the issue price, $96.62, as shown in the first row in the amortisation schedule.
As shown in the second row in the amortisation schedule, the coupon interest of $10 was paid during
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the period ended t1, but the effective interest expense on the amount of cash raised on issue of
the debt was $11.59 ($96.62 × 0.12). The difference between the effective interest, $11.59, and the
coupon interest, $10, was the amortised discount for the period, $1.59. The unamortised discount at
t1 was $1.79, which is the difference between the balance of the unamortised discount at t0 and the
discount that was amortised for the period ended t1. As there were no principal repayments until t2,
the amortised cost of the debt at t1 was $98.21 ($96.62 + $1.59).
Fair value
The first value-based measure shown in Figure 1.6 is fair value. This is defined in IFRS 13
Fair Value Measurement as:
the price that would be received to sell an asset or paid to transfer a liability in an orderly
transaction between market participants at the measurement date (IFRS 13, para. 9).
A fair value measurement assumes that the asset or liability is exchanged in an orderly transaction
between market participants (IFRS 13, para. 15). The assumptions of an orderly transaction are
identified in IFRS 13 as follows:
A transaction that assumes exposure to the market for a period before the measurement
date to allow for marketing activities that are usual and customary for transactions involving
such assets or liabilities; it is not a forced transaction (e.g. a forced liquidation or distress sale)
(IFRS 13, Appendix A).
The assumption of an orderly transaction is important for fair value. This enables fair value to
reflect an amount at which market participants would willingly exchange an item rather than
a ‘liquidation’ or ‘fire-sale’ price that might be achieved in a forced sale if the vendor were
financially distressed.
Fair value can be considered in terms of an entry price or exit price. The IFRS 13 definition
of fair value is an exit price—the ‘price that would be received to sell an asset or paid to
transfer a liability.’ (IFRS 13, Appendix A). This can be compared to an entry price, which is the
‘price paid to acquire an asset or received to assume a liability in an exchange transaction.’
(IFRS 13, Appendix A).
IFRS 13 does not prescribe the use of fair value. Rather, it establishes a hierarchy for the
measurement of fair value when another standard prescribes or permits its use. The hierarchy
ranks the inputs to valuation techniques based on their verifiability so as to enhance comparability
and consistency. The highest rank (Level 1) is given to inputs that reflect quoted market prices
for identical assets or liabilities, and the lowest rank (Level 3) is assigned to inputs that cannot be
observed in a market.
These levels are described as:

• Level 1 inputs: quoted price for an identical asset or liability—These inputs reflect
quoted prices for identical assets or liabilities in active markets. For example, if a blue chip
ordinary share is valued, the stock exchange price for the share is a Level 1 input. Note that
the effective implementation of this level requires careful consideration of the definition of
‘active markets’.
• Level 2 inputs: model with no significant unobservable inputs—Where Level 1 inputs are
not available, fair value is estimated using a model with no significant unobservable inputs.
For example, the entity may use quoted market prices for comparable assets, liabilities or
equity instruments in active markets. Other examples include option valuation models or
PV techniques.
• Level 3 inputs: model with significant unobservable inputs—When quoted prices and
other observable inputs are not available, the entity uses inputs that are developed on the
basis of the best information available about the assumptions that market participants would
use when pricing the asset or liability. For example, unobservable inputs into a valuation
model for residential mortgage-backed securities include prepayment rates, probability of
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default and the severity of loss.
Fair value is considered by many to be more relevant than cost-based measures. However,
fair value has been criticised for reasons such as:
• lack of relevance to decision-making—in relation to assets that the entity does not intend
to sell, such as financial instruments that the entity intends to hold to maturity
• reliability problems—in relation to measuring the fair value of assets that are not traded
in an active market.
➤➤Question 1.8
Stanley Ltd holds a parcel of Alpha B redeemable 7 per cent cumulative preference shares issued by
Alpha Ltd. The Alpha B preference shares are unlisted. Stanley Ltd’s financial accountant measured
the value of the shares using the market price of Alpha A preference shares, which are listed,
redeemable, cumulative 5 per cent preference shares, issued by Alpha Ltd. The Alpha A preference
shares have a very similar maturity date to the Alpha B preference shares. The accountant
determined the yield of the Alpha A preference shares by reference to the quoted price and to
the timing and amount of the contractual cash flows. The accountant then applied the same yield
in a discounted cash flow model, using the contractual cash flows of Alpha B preference shares.
Which input level has the accountant used to measure the fair value of the Alpha B preference
shares? Give reasons for your answer.
Current cost
Current cost is the second value-based measure shown in Figure 1.6. The current cost of
an asset is the amount of cash or cash equivalents that would have to be paid if the same or
an equivalent asset were acquired currently (Conceptual Framework, para. 4.55(b)). The current
cost of a liability refers to the undiscounted amount of cash or cash equivalents that would
be required to settle the obligation currently (Conceptual Framework, para. 4.55(b)).
Study guide | 49
In relation to assets, the definition implies that there are two concepts of current cost:
1. reproduction cost—current cost of replacing an existing asset with an identical one
2. replacement cost—current cost of replacing an existing asset with an asset of equivalent
productive capacity or service potential.
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The current cost of replacing or reproducing an asset is commonly interpreted as the most
economic cost to replace the asset (IASB 2005, p. 97). Therefore, reproduction or replacement
cost may differ from historical cost where an entity could, through efficiencies, reproduce or
replace the service potential of an asset for an amount that differs from the fair value of the
purchase consideration given to acquire the asset.
Current cost (more specifically, current replacement cost) is an example of an entry price
valuation technique.
In some instances, reproduction of an existing asset, such as a brand name, may not be feasible
because of its uniqueness. Difficulties may also arise with replacing an asset with one that
provides equivalent capacity because advances in technology may mean that any available
replacement asset would increase capacity. For example, it would be difficult to replace a
computer without increasing capacity or service potential because of the rapid advances in
computer technology.
Current cost has been criticised on a number of grounds, including the following:
• Lack of relevance to decision-making

–– Current cost is not a measure of the value received but of the amount of the sacrifice
that would be required to replace an asset, and therefore, it has limited predictive value.
–– Financial information based on current cost is difficult to interpret where an entity does
not intend to replace its assets.
–– Current cost’s applicability to non-renewable or irreplaceable assets such as oil and gas
reserves is questionable.
–– Current cost is not an independent measurement attribute. It must be supplemented by
additional rules to ensure that the amount represented by current cost is recoverable.
• Reliability problems
–– Reliability may be reduced by the need to identify assets of equivalent productive
capacity or service potential and by measuring their most economic current cost.
–– There may be uncertainty about the reliability of measurement because replacement
cost is an entity-specific measure that depends on management’s strategies and
intentions about the level of capacity at which the asset is used.
• Comparability problems
–– Management strategies and expectations with respect to the assets concerned
(e.g. nature of the use of a building and whether it is fully occupied) may change
in response to changes in the business environment or over time.
–– There may be significant differences between entities in the determination
of current cost.
➤➤Question 1.9
Refer to Question 1.7 regarding the Sydney Harbour Bridge. How might using an alternative
measure, such as current cost, overcome the limitations of cost outlined in that question?
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The third value-based measure shown in Figure 1.6 is fair value less costs of disposal, is a
variant of fair value used in some standards. For example, fair value less costs of disposal is
used in IAS 36, which defines the recoverable amount of an asset or cash-generating unit
as ‘the higher of its fair value less costs of disposal and its value in use’ (IAS 36, para. 6).
Costs of disposal are the ‘incremental costs directly attributable to the disposal of an asset
or cash‑generating unit, excluding finance costs and income tax expense’ (IAS 36, para. 6).
Finance costs and income tax are similarly excluded from the measurement of costs to sell by
IFRS 5 Non-current Assets Held for Sale and Discontinued Operations (Appendix A).
Net realisable value

The fourth value-based measure shown in Figure 1.6 is net realisable value. This approach
measures the economic benefits that an entity expects to derive from selling an asset in the
ordinary course of business. The use of net realisable value in financial reporting is largely
restricted to its role in measuring inventories at the lower of cost and net realisable value,
in accordance with IAS 2 Inventories. Net realisable value is:
the estimated selling price in the ordinary course of business less the estimated costs of completion
and the estimated costs necessary to make the sale (IAS 2, para. 6).
Applied to inventory, net realisable value is a measure of the net amount that the entity expects
to derive from the sale of the asset in the ordinary course of business.
Net realisable value differs from fair value less costs to sell, which measures the amount that
could be obtained from selling the asset in its current state. Net realisable value measures the
benefits that the entity expects to realise from the asset in the ordinary course of business.
If the inventory is in a complete state, there is generally no difference between the two values.
However, work-in-progress inventory would be completed before being sold in the ordinary
course of business. Accordingly, the net realisable value of work-in-progress inventory usually
differs from its fair value less costs to sell.
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Net realisable value may also reflect entity-specific expectations regarding the estimated selling
price in the ordinary course of business, the estimated cost of completion and costs necessary to
make the sale. These expectations may not be in accordance with market expectations on which
fair value would generally be based. For example, a second-hand car dealer may sell a specific
model of car for $10 000 in the normal course of business. Hence, the net realisable value of
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the car to the dealer is $10 000. The same car is available for sale on second-hand car websites
for $8000, without selling costs, through private sales, which may be used as an indicator of fair
value. Therefore, if the second-hand car belongs to an entity whose main business is not to sell
cars, the entity may consider the fair value of the car as $8000. In this case, the fair value is $8000,
and the net realisable value is $10 000.
A criticism of the net realisable value basis of measurement is that the netting of costs to
complete the asset and make a sale against the estimated selling price can result in recognising
liabilities for future costs for which there is no present obligation. Such a practice would be
inconsistent with the definition of liabilities in the Conceptual Framework. It should be noted
that this problem does not arise in the measurement of inventory at the lower of cost and net
realisable value, where the effect of measurement at net realisable value involves decreasing,
rather than increasing, the carrying amount of inventory.
For example, assume an entity manufactures fence posts at a cost of $5 per post. The entity was
initially expecting to sell each fence post for $8, making a pre-tax profit of $3. However, due to
a downturn in the fencing industry, the entity has reliable evidence that the fence posts will now
only be sold for $4 each. The entity is required to write the inventory down to its net realisable
value of $4 per post, with $1 for each post being recognised as an expense in the statement of
profit or loss (P&L) in accordance with IAS 2 Inventories.
Realisable (settlement) value

The fifth value-based measurement shown in Figure 1.6 is realisable (settlement) value, which is
defined in the Conceptual Framework:
Assets are carried at the amount of cash or cash equivalents that could currently be obtained by
selling the asset in an orderly disposal. Liabilities are carried at their settlement values; that is,
the undiscounted amounts of cash or cash equivalents expected to be paid to satisfy the liabilities
in the normal course of business (para. 4.55(c)).
The Conceptual Framework refers to a measurement concept that can be applied to both
assets and liabilities. As several variations of realisable value (including fair value less costs to
sell and net realisable value) have already been considered for assets, the discussion of realisable
(settlement) value will emphasise the application of this concept to liabilities.
The definition of settlement value used in the Conceptual Framework differs from the concept of
the fair value of a liability used by the IASB in IFRS 13 Fair Value Measurement. The fair value of a
liability is the amount that would be paid to transfer a liability in an orderly transaction between
market participants at the measurement date. In contrast, the settlement value refers to the
amount that would be paid to settle the liability with the counterparty.
The price paid to transfer a liability represents a market-based fair value measurement of
the liability because it is independent of entity-specific considerations. The settlement value
embodies entity-specific considerations, including whether the entity should settle the liability
using its own internal resources and the efficiency with which an entity can settle a liability
(which depends on the advantages and disadvantages that a particular entity has relative to
the market).
Value in use
The sixth and final value-based measure shown in Figure 1.6 is value in use. This measure is
defined in IAS 36 (para. 6) as ‘the present value of future cash flows expected to be derived from
an asset or cash-generating unit’. Value in use is also frequently referred to as the ‘entity-specific
value’. The value in use should reflect the estimated future cash flows that ‘the entity expects
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to derive from the asset’ (IAS 36, para. 30(a)). However, other elements of the value-in-use
computation may reflect market expectations rather than the entity’s expectations. For example,
the discount rate that is applied to the expected cash flows must reflect the current market
assessment of the time value of money and the risks specific to the asset for which the future
cash flow estimates have not been adjusted (IAS 36, para. 55).
The entity-specific value-in-use measurement basis has the following advantages:

• Management is in the best position to judge the expected amount, timing and risk of future
cash flows. Accordingly, financial statements are considered to be more relevant and reliable
where they reflect management intentions and expectations.
• Management would be held more accountable against measurements that reflect entity-
specific management objectives.
The criticisms of the value-in-use basis of measurement include:
• Reliability problems
–– Because value in use is normally calculated as the discounted net proceeds from the use
of an asset, it is specific to each entity and to each specific use. It therefore relates to only
one specific future course of action or combination of actions.
–– Value in use is subjective and is not capable of being independently verified by others.
–– The application of value in use to assets that do not generate contractual cash flows
is problematic.
–– An individual asset may work with other assets to generate cash flows. This results in the
need to allocate expected cash flows across assets. These allocations may be arbitrary.
• Understandability. The lack of clarity regarding whether value in use should reflect
management or market expectations.
Valuation techniques
The Conceptual Framework describes present value in the following terms:
Assets are carried at the present discounted value of the future net cash inflows that the item
is expected to generate in the normal course of business. Liabilities are carried at the present
discounted value of the future net cash outflows that are expected to be required to settle the
liabilities in the normal course of business (para. 4.55(c)).
Figure 1.6 shows present value separately, as it is not a measurement basis; rather, it is a
measurement technique that can be used to estimate other measurement bases. For example,
amortised cost and value in use rely on present value calculations. Similarly, IFRS 13 Level 2
or Level 3 fair values may be determined based on a present value technique (IFRS 13,
para. 74). The IFRSs require the use of appropriate valuation techniques. For example,
IFRS 13, para. 61, states:
An entity shall use valuation techniques that are appropriate in the circumstances and for which
sufficient data are available to measure fair value, maximising the use of relevant observable inputs
and minimising the use of unobservable inputs.
Issues that arise in the application of the valuation techniques include:

• the uncertainty of future cash flows
• the selection of an appropriate discount rate.
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Uncertainty of future cash flows

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

Another complexity in the application of valuation techniques is the need to select an appropriate
discount rate. PV may be sensitive to the rate chosen for the purpose of discounting future
amounts to a PV.
According to contemporary finance theory, investors require a rate of return that is commensurate
with the systematic risk of an investment, irrespective of whether the investment is in a financial
asset or a project involving non-monetary assets. Therefore, for the purpose of project evaluation,
managers should use a current, market-determined, risk-adjusted discount rate that reflects the
systematic risk of the asset, or group of assets, concerned.
The total risk of an asset comprises systematic risk and unsystematic risk. Systematic risk is
sometimes referred to as market risk or non-diversifiable risk. Systematic risk relates to the
extent that the variability of the return earned on an asset, or group of assets, is due to economy-
wide factors affecting all assets. It can be contrasted with unsystematic risk, the risk that is
specific to a particular asset due to that asset’s unique features. Investors can drive asset-specific
(unsystematic) risk towards zero by holding a diversified portfolio of assets. However, systematic
risk cannot be eliminated in this manner. Because investors can eliminate unsystematic risk,
equilibrium returns reflect only the risk-free rate plus a return for bearing systematic risk in
excess of the risk-free rate.
It is important to note that this conclusion emerges from the investor’s capacity to diversify, either
directly or via a mutual fund. It is unrelated to a producing entity’s capacity, or lack of capacity,
to diversify its investment projects. As investors can diversify their investments, diversification
or lack thereof by a producer does not add or reduce value for investors. Investors will not pay
any more than the price associated with the return required to compensate for systematic risk.
This means that producing entities should accept a project that has a positive net present value
when the cash flows are discounted at a rate adjusted for the systematic risk of the project. That is,
each project has its own discount rate adjusted for systematic risk.
There is a preference in accounting pronouncements for using discount rates that are risk-
adjusted when measuring the present values. For example, IAS 19 Employee Benefits states:
The rate used to discount post-employment benefit obligations (both funded and unfunded) shall
be determined by reference to market yields at the end of the reporting period on high quality
corporate bonds. For currencies for which there is no deep market in such high quality corporate
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bonds, the market yields (at the end of the reporting period) on government bonds denominated
in that currency shall be used. The currency and term of the corporate bonds or government
bonds shall be consistent with the currency and estimated term of the post-employment benefit
obligations (IAS 19, para. 83).
Another issue is whether to use a current market rate (whether risk-free or risk-adjusted)
or the historical interest rate implicit in the original transaction. Historical and current rates
are now considered.
Historical rates
In the context of a historical cost system, the historical interest rate implicit in the original
contract is usually considered to be the rate at which the cash flows specified in the contract are
to be discounted. At the date of issuing a financial instrument, the discount rate implicit in the
original contract is the effective rate demanded by lenders. Where a financial instrument is traded
in an active market, the discount rate implicit in the original contract is a market‑determined,
risk-adjusted discount rate, current at the date of issue of the financial instrument.
Pronouncements that require the use of historical rates include IFRS 9 Financial Instruments.
Certain financial liabilities and assets are carried at amortised cost, using the effective-interest-
rate method (IFRS 9, paras 4.1.1 and 4.2.1).
IFRS 16 Leases requires lease liabilities and receivables to be recognised initially by lessees and
lessors by discounting the relevant cash flows to present values using the interest rate implicit
in the lease (IFRS 16, paras 26 and 68).
Current rates
Current rates are based on a discount rate that is current at the end of the reporting period.
Current rates may be adjusted for risks (unless risks are otherwise adjusted for in the estimated
cash flows) and may be market-determined. The use of current market based, risk-adjusted rates
in determining PV is more consistent with a fair value approach to measurement, because it
reflects the rate that the market would use to discount the expected future cash flows.
Examples of pronouncements that specify the use of current rates include:

• IAS 19 Employee Benefits. The standard adopts the position that employer obligations
arising from defined benefit plans and other long-term employee benefits, such as long
service leave (LSL), are measured at their present values at the end of the reporting period.
The rate used to discount such obligations is determined by reference to market yields on
high-quality corporate bonds with equivalent terms and currency at the end of the reporting
period (para. 83).
• IAS 37 Provisions, Contingent Liabilities and Contingent Assets. The standard requires
provisions to be measured at present value using ‘… a pre-tax rate (or rates) that reflect(s)
current market assessments of the time value of money and the risks specific to the liability’
(para. 47).
• IAS 36 Impairment of Assets requires that the discount rate used in determining value in use
be a pre-tax rate that reflects current market assessments of the time value of money and the
risks specific to the asset for which the future cash flows have not been adjusted (para. 55).
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Application of measurement principles in the

International Financial Reporting Standards
Mixed measurement models are adopted in various forms with a focus on different measures
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and applications to provide accounting policy choice and, in some instances, to determine the
required measurement basis. Where there is accounting policy choice, accountants have the
ability to exercise judgment according to the circumstances. At the same time, some degree
of comparability in measurement is maintained through the IFRSs.
Accounting standards provide the practical mechanism for achieving the overall objectives of
financial reporting, as well as outlining how best to achieve as many qualitative characteristics
as possible. By specifying how accounting information should be treated and reported,
different organisations can gain considerably more consistency and understandability than
would be achieved if they used their own judgment when reporting their financial affairs. It also
limits the scope for abuse and misreporting that may arise when the economic self-interest of
organisations or their managers interferes with objective reporting.
Accounting standards go beyond specifying how items must be reported; they provide detailed
discussion of why the mandated approaches are required.
This section will take a closer look at the mixed measurement model applied in the IFRSs.
This discussion will focus on the following selected IFRSs:
• IFRS 16 Leases
• IAS 19 Employee Benefits
• IFRS 2 Share-based Payment
• IAS 40 Investment Property.
These issues have been selected because of their commercial relevance and their common
application in financial statements. The following discussion will also explain and highlight how
different the application of measurement principles can be.
Leases
A new standard for leases was issued in 2016 and replaces IAS 17. This new standard, IFRS 16
Leases, applies to annual reporting periods beginning on or after 1 January 2019, but may be
applied earlier by entities that are applying IFRS 15 Revenue from Contracts with Customers
before this date (IFRS 16, Appendix C, para. C1). The objective of IFRS 16 is to provide the
principles for ‘recognition, measurement, presentation and disclosure of leases’ in a manner that
faithfully represents the effect of leases on an entity’s financial position, financial performance
and cash flows (IFRS 16, para. 1). The parties to a lease contract are the lessee and the lessor.
The lessee is the entity that obtains the right to use the asset, and the lessor is the entity that
provides the right to use the asset (IFRS 16, Appendix A).
There are two recognition exemptions available to lessees. They apply to ‘short-term leases’
and low value leases (IFRS 16, para. 5). A lease is considered short-term if it is for no more than
12 months (IFRS 16, Appendix A) and the short-term lease exemption can only be applied to a
class of underlying assets, not on the basis of the terms of each lease contract (IFRS 16, para. 8).
The assessment of whether the underlying asset is of low value is based on the value of the asset
when it is new (IFRS 16, Appendix B, para. B3) and cannot be applied to subleases (IFRS 16,
Appendix B, para. B7). The underlying asset is only of low value if:
a) the lessee can benefit from use of the underlying asset on its own or together with other
resources that are readily available to the lessee; and
b) the underlying asset is not highly dependent on, or highly interrelated with, other assets
(IFRS 16, Appendix B, para. B5).
Tablets and personal computers, telephones, and small items of office furniture are examples of
underlying assets of low value (IFRS 16, Appendix B, para. B8). The actual amount that constitutes
a low-value is not specified in IFRS 16, however, BC100 of IFRS 16 states that the IASB’s view of
low-value is “in the order of magnitude of US$5000 or less”.
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IFRS 16 requires entities to use professional judgment when determining if a lease exists and,
if it does, the impact it will have on the financial reporting of the entity. Each contract must be
assessed at its commencement to determine if it contains a lease. A contract contains a lease
if it ‘conveys the right to control the use of an identified asset for a period of time in exchange
for consideration’ (IFRS 16, para. 9). The period of time is commonly greater than 12 months but
it may also be expressed as an ‘amount of use’. For example, the number of units produced by
the underlying asset. The existence of a lease must be reassessed each time there is a change
to the terms and conditions of the contract (IFRS 16, paras 9–11).
Professional judgment must again be used in considering whether or not a lessee is ‘reasonably
certain’ to exercise specific options that will impact the lease term and the measurement criteria.
For example, the lease term includes the ‘non-cancellable period’ plus periods covered by
an option to ‘extend the lease if the lessee is reasonably certain to exercise that option’ and
to ‘terminate the lease if the lessee is reasonably certain not to exercise that option’ (IFRS 16,
para. 18).
If you wish to explore this topic further, read paras 9–21 of IFRS 16.
Recognition criteria for the lessee

At the commencement date of a lease the lessee recognises a right-of-use asset at cost and a
lease liability (IFRS 16, paras 22–3). A right-of-use asset is the asset specified in the lease contract
that the lessee has the right to use during the lease term. The recognition and measurement
criteria for a lessee are summarised in Table 1.8.
Table 1.8: Recognition and measurement criteria for the lessee
Right-of-use asset† Lease liability‡
Initial measurement Initial measurement

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

Unless alternative measurement models The lease liability is measured by:
(see ‘Alternatives’) are applied, the lessee applies
(a) increasing the carrying amount to reflect
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the cost model under which the right-of-use
interest on the lease liability;
asset is measured.
(b) reducing the carrying amount to reflect
To apply a cost model: the lease payments made; and
• measure at cost less accumulated depreciation
(c) remeasuring the carrying amount to reflect
and accumulated impairment losses
any reassessment or lease modifications
• adjust for any remeasurements of the lease
… or to reflect revised in-substance fixed
liability (IFRS 16, paras 29–30).
lease payments (IFRS 16, para. 36).
Alternatives
Other measurement models may be used under the
following circumstances:
• ‘If a lessee applies the fair value model in IAS 10
Investment Property to its investment property’,
then the fair value model is applied to the right-
of-use assets.
• The revaluation model may be applied per
IAS 16 Property, Plant and Equipment if the
lessee has applied that model to a class of
property, plant and equipment to which the
right-of-use asset relates (IFRS 16, paras 34–5).

†
For further exploration of this topic, read paras 23–5 and 29–35 of IFRS 16.

‡
For further exploration of this topic, read paras 26–8 and 36–43 of IFRS 16.
Source: Adapted from IFRS Foundation 2017, IFRS 16 Leases, in 2017 IFRS Standards,
IFRS Foundation, London, pp. A719–B1932.
Example 1.6: Accounting for leases by lessee

On 30 June 20X4, A Ltd (lessor) leased a motor vehicle to B Ltd (lessee). At that date, the fair value
of the vehicle is $68 000, its estimated residual value at the end of the lease term is $10 000 and its
economic useful life is six years. The lease is cancellable but the lessee will incur a penalty equal to
24 months of lease payments if it chooses this option. For the purposes of this example, we will assume
the lessee does not cancel the lease. There is no option for the lessee to purchase the vehicle at the end
of the lease term. The lease agreement cost A Ltd $2647 to set up and included the following details:
Annual lease payments (payable 30 June each year in advance) $19 800
Executory costs (included in annual lease payment)† $1 800
Residual value guarantee $6 000
Unguaranteed residual value $4 000
Lease term 4 years
Interest rate implicit in the lease 9%

†
The executory costs relate to the reimbursement of insurance and maintenance costs which will be paid
annually by A Ltd.
The first step for the lessee, B Ltd, is to determine the value of the right-of-use vehicle and the lease
liability to be recognised at the commencement date of the lease.
The value of the right-of-use vehicle is equal to the value of the lease liability plus any lease payments
made at the beginning of the lease term. The lease liability is the present value of the future lease
payments (including the guaranteed residual value to be paid at the end of the lease term). The present
value of the lease payments is calculated as:
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Interest rate = 9% $ $

Payment in advance each year for remaining 3 years 18 000 45 563 †
Guaranteed residual at end of 4 years 6000 4 250 ‡
Lease liability = PV of future lease payments 49 813
Plus first payment in advance (30 June 20X4) 18 000
Cost of right-of-use asset 67 813
Plus PV of unguaranteed residual at end of 4 years 4000 2 834 ‡
Total Present Value of Lease 70 647

A quick reconciliation can be performed to confirm that the present value of the lease equals the fair
value of the underlying assets plus incidental direct costs.
Fair value 68 000
Incidental direct costs to lessor 2 647
FV + Incidental Direct Costs 70 647
†
PV factor of an annuity at 9 per cent over 3 years = 2.5313. $18 000 × 2.5313 = $45 563.
‡
PV factor of a lump sum in 4 years time at 9 per cent = 0.7084. Guaranteed residual of $6000 × 0.7084 =
$4250. Unguaranteed residual of $4000 × 0.7084 = $2834.
Once the values have been determined the lessee can then prepare the following schedule of
lease payments.
Lease Payments Schedule for B Ltd (Lessee)
Interest Reduction Balance
Lease payments† expense‡ in liability§ of liability||
30.06.20X4 49 813#
30.06.20X5 18 000 4 483 13 517 36 296
30.06.20X6 18 000 3 267 14 733 21 563
30.06.20X7 18 000 1 941 16 059 5 504
30.06.20X8 6 000 496 5 504
60 000 10 187 49 813
†
Future lease payments of $18 000 payable in advance.
‡
Balance of liability each year × interest rate of 9 per cent.
§
Lease payments less interest expense. The total must equal the initial lease liability recognised.
||
Balance of liability each year less the reduction in the liability.
#
The PV of the total lease payments (also equal to the value of the right-of-use asset) less any payments
made at beginning of the lease term.
➤➤Question 1.10
Using the information provided in Example 1.6, prepare the journal entries to be recorded by
the lessee (B Ltd) throughout the lease term.
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Recognition criteria for the lessor

A lessor is required to classify each of its leases as either a finance lease or operating lease
(IFRS 16, para. 61). A finance lease is defined in Appendix A as ‘a lease that transfers substantially
all the risks and rewards incidental to ownership of an underlying asset’. An operating lease
is defined in Appendix A as ‘a lease which does not transfer substantially all the risks and
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rewards incidental to ownership of an underlying asset’. It is the substance of the transaction
rather than the form of the contract that determines whether a lease is classified as a finance or
operating lease.
Situations that lead to classification of a finance lease include:

• ownership is transferred to the lessee by the end of the lease term
• an option for the lessee to purchase the underlying asset at a price that is sufficiently lower
than its fair value at the date the option becomes exercisable for it to be reasonably certain
• the term of the lease is for the majority of the underlying asset’s economic life (Note: IFRS 16
does not specify what constitutes the majority or ‘major part’ of the asset’s economic life.
This would be a matter of professional judgment and needs to consider the substance
of the lease and whether or not substantially all of the risks and benefits of ownership
are transferred.)
• the present value of the lease payments amount to substantially all of the fair value of the
underlying asset
• the specialised nature of the underlying asset means only the lessee can use it without
major modifications
• the lease is cancellable and the lessor’s associated losses are to be incurred by the lessee
thus indicating a transfer of risks and rewards of the underlying asset to the lessee
• gains or losses from changes in the residual amount’s fair value are accrued to the lessee
• the lessee may continue the lease for another period with the rent amount ‘substantially
lower’ than market value (IFRS 16, paras 63–4).
If you wish to explore this topic further, read paras 61–6.
Lessors of operating leases must recognise the lease payments as income on a straight-line or
other systematic basis if that is representative of the benefit pattern of the underlying asset.
Initial direct costs incurred in obtaining the operating lease are added to the carrying amount
of the underlying asset and recognised as an expense over the lease term using the same basis
as the lease income (IFRS 16, paras 81–3).
The recognition and measurement criteria for lessors are summarised in Table 1.9.
Table 1.9: Recognition criteria for the lessor
Finance lease† Operating lease‡
Initial measurement Initial measurement

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The net investment in the lease comprises: Lease payments received are recognised as
• initial direct costs incurred by lessor ‘other income on a straight-line or other systematic basis
than those incurred by manufacturer or dealer that is representative of the pattern of benefit
lessors’ (IFRS 16 Leases, para. 69) from the use of the underlying asset.
• fixed payments, less lease incentives payable
• variable lease payments Initial direct costs are added to the carrying
• residual value guarantees provided by the amount of the underlying asset and recognised
lessee or a third party as an expense on the same basis as the lease
• exercise price of purchase option if lessee income (IFRS 16, paras 81–3).
is reasonably certain they wish to exercise
that option
• payments of penalties for terminating the lease.
The interest rate implicit in the lease is used to

meas-ure the net investment in the lease
(IFRS 16, paras 68–70).
Specific recognition criteria for manufacturer or

dealer lessors are set out in IFRS 16 (paras 71–4).
Subsequent measurement Subsequent measurement

Finance income is recognised on a systematic basis Depreciation is recognised as an expense in
over the lease term. Lease payments are applied accordance with IAS 16. The underlying asset
against the gross investment to reduce the principal should be tested for impairment and any
amount and the unearned finance income (IFRS 16, impairment loss recognised in accordance with
paras 75–8). IAS 36 Impairment of Assets (IFRS 16, paras 84–6).
†
For further exploration of this topic, read paras 67–78 of IFRS 16.
‡
For further exploration of this topic, read paras 81–6 of IFRS 16.
Source: Adapted from IFRS Foundation 2017, IFRS 16 Leases, in 2017 IFRS Standards,
IFRS Foundation, London, pp. A719–B1932.
Example 1.7: Accounting for leases by lessor

This example uses the information provided in Example 1.6.
The first step for the lessor is to determine if the lease is a finance lease or an operating lease,
by applying the guidance in paras 63 and 64 of IFRS 16. This is to assess if the information (individually
or in combination) satisfied the criteria for classification as a finance lease.
• The lease agreement does not include an option for B Ltd to purchase the vehicle at the end of
the lease term. Therefore, the transfer of ownership test is not satisfied.
• The vehicle is not of a specialised nature that makes it useful only for B Ltd. Therefore,
the specialised nature test is not satisfied.
• The lease term is for four years, which is 66.67 per cent of the vehicle’s useful economic life of
six years. Assuming the expected benefits of the vehicle are receivable evenly over its useful
life, it could be argued that the lease is for the majority of the underlying asset’s economic life.
Therefore, the lease term test is satisfied.
• The present value of the lease payments of $67 813 represents almost all of the fair value of the
vehicle, $68 000. Therefore, the present value test is satisfied.
• Although the lease agreement is cancellable, the monetary penalty of 24 months of lease payments,
to be incurred by B Ltd, indicates that the risks associated with the underlying asset have been
transferred to the lessee.
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Professional judgment must be applied to determine if the listed indicators are showing if the vehicle
is under a finance or an operating lease. The main indicators are the:
• relatively low residual value at the end of the lease term
• majority of the fair value being covered in lease payments over a four-year period instead of the
vehicle’s full useful life of six years
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• substantial monetary penalty for cancellation of the lease.
Without further information, it would likely be concluded that the lease is a finance lease, as substantially
all the risks and rewards of the vehicle are to be passed to B Ltd.
Assuming A Ltd classifies the lease of the vehicle as a finance lease, A Ltd can now prepare a sched-
ule of lease receipts. The amount recognised by the lessor includes the unguaranteed residual value.
The calculations in Example 1.6 show the present value of this amount to be $2834. Therefore, the full
amount receivable is $67 813 plus $2834 = $70 647.
Lease Receipts Schedule for A Ltd (Lessor)

Interest Reduction in Balance of
Lease receipts† (i) revenue‡ (ii) receivable§ (iii) receivable|| (iv)
30/06/20X4 (v) #70 647
30/06/20X4 18 000 18 000 52 647
30/06/20X5 18 000 4 738 13 262 39 385
30/06/20X6 18 000 3 545 14 455 24 930
30/06/20X7 18 000 2 244 15 756 9 174
30/06/20X8 10 000 826 9 174
82 000 11 353 70 647
†
Four annual receipts payable in advance. Residual value on last day of lease term is the full amount of the
residual value ($6000 guaranteed; $4000 unguaranteed).
‡
Balance of receivable each year × interest rate of 9 per cent.
§
Lease receipts less interest revenue. Total must equal the initial amount of the lease receivable.
||
Balance of receivable less the reduction in receivable.
#
Initial receivable amount equals the fair value of $68 000 plus initial direct costs of $2647. This amount
should also equal the PV of the lease payments receivable (calculated in previous example) and the PV
of the unguaranteed residual value.
➤➤Question 1.11
Using the information provided in Example 1.7 prepare the journal entries to be recorded by
the lessor (A Ltd) throughout the lease term.
Presentation and disclosure

There are presentation and disclosure requirements for the lessee and the lessor to assist users
of financial statements to determine the effect of leases on the entity’s financial situation. For a
lessee, the right-of-use assets and the lease liabilities shall be reported separately from other
assets and liabilities in either the financial statements or the notes. The exception to this is if the
right-of-use asset is classified as investment property, which shall be presented in the statement
of financial position as investment property. Interest incurred on the lease liability must be
included as a component of finance costs and presented separately from depreciation expense
on the right-of-use asset.
Disclosure requirements for the lessor include additional qualitative and quantitative information
regarding the nature of their leasing activities and their risk management strategy for the rights
they retain in the underlying assets. These disclosure requirements are also dependent on
whether the lease is classified as a finance or operating lease.
If you wish to explore this topic further, read paras 47–53 and 88–97 of IFRS 16.
Employee benefits
The principles for accounting for employee benefits are prescribed in IAS 19 Employee Benefits.
The standard defines employee benefits as ‘all forms of consideration given by an entity in
exchange for service rendered by employees or for the termination of employment’ (IAS 19,
para. 8).
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Short-term employee benefits

Short-term employee benefits are defined as:
employee benefits (other than termination benefits) that are expected to be settled wholly before
12 months after the end of the annual reporting period in which the employees render the related
service (IAS 19, para. 8).
Examples of short-term employee benefits include: wages and salaries; profit-sharing and
bonuses; non-monetary benefits such as medical care; and short-term compensated absences
such as annual leave and sick leave (IAS 19, para. 9). The liability for short-term benefits should
be measured at the undiscounted amount expected to be paid on settlement of the obligation.
Recognition of the liability will usually give rise to a corresponding expense, although in some
circumstances it may be included in the carrying amount of an asset such as plant and equipment
or inventory.
If you wish to explore this topic further, read paras 9–11 of IAS 19.
Employees may be entitled to compensation for absences for a variety of reasons, including
annual leave, sick leave and LSL. In accordance with para. 11 of IAS 19, short-term compensated
absences must be recognised at the undiscounted amount of employee benefit that the entity
expects to pay for the employees’ services. Compensated absences that are expected to
be settled beyond 12 months after the end of the reporting period are measured using the
PV technique (IAS 19, paras 153–5).
When compensated absences are considered, it is important to distinguish between:

• accumulating and non-accumulating benefits
• vesting and non-vesting benefits.
An accumulating compensated absence arises where the employees can carry forward their
entitlements to future periods. If the compensated absence does not accumulate, they lapse
if not fully used within the current period and are not payable to the employee on leaving the
entity (IAS 19, para. 18).
An accumulating compensated absence may be vesting or non-vesting. A vesting benefit

arises when the employer is obligated to pay any unused benefits to the employee on their
leaving the entity (IAS 19, para. 15). That is, the employer is obligated to settle a vesting benefit,
even if the employee resigns or their employment is terminated. For vesting compensated
absences, the employee will be paid either when the leave is taken or on termination
of employment.
If a compensated absence is non-accumulating, the cost of providing the benefit is not

recognised until the absence occurs (IAS 19, para. 13(b)). A liability is not recognised before
leave is taken because the employee’s service does not increase the amount of the leave benefit
and benefits lapse as each year ends (IAS 19, para. 18).
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When a compensated absence is accumulating and vesting, a liability for accumulated

compensated absences is recognised, as employees render services that increase their
entitlement to future compensation (IAS 19, para. 13(a)). In accordance with IAS 19, the nominal
approach is used for accumulated unused compensated absence benefits that the entity
expects to settle within 12 months after the reporting period (paras 11–16).
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For compensated absences that are accumulating but non-vesting, the employee is only
compensated for absences taken (e.g. in Australia this is usually the case with sick leave).
On termination of employment, the employee is not compensated for any unused entitlement.
Despite this, it can be argued that the definition of a liability is satisfied for unused benefits. That is,
there has been a past event (rendering services) that results in an obligation for accumulating,
non-vesting compensated absences to be carried forward as part of the employee’s benefits.
However, whether a liability for an accumulating, non-vesting compensated absence is recognised
depends on the probability that a payment will be made. For this reason, IAS 19 specifies that
entities should:
measure the expected cost of accumulating paid absences as the additional amount that the
entity expects to pay as a result of the unused entitlement that has accumulated at the end of the
reporting period (IAS 19, para. 16).
A liability for non-vesting compensated absences should be recognised only for that part of
the accumulated entitlement that is expected to result in additional payments to employees.
The probability that the leave will be taken affects the decision to recognise the liability and
the amount of the liability, if any, that is recognised.
If you wish to explore this topic further, read paras 9–11 of IAS 19, noting in particular the
‘Example Illustrating Paragraphs 16 and 17’.
➤➤Question 1.12
An entity has 500 employees who are provided with 10 days sick leave for each year of service
on a non-vesting accumulating basis. At 30 June 20X6, 20 per cent of employees had taken their
full entitlement of sick leave. The remaining employees had an average of 12 days’ accumulated
leave. Past experience indicates that:
• 20 per cent of employees use all of their sick leave in the year in which they become entitled
to it and therefore have no accumulated sick leave at the end of the year
• 50 per cent of the entity’s employees use six days of accumulated sick leave in years
subsequent to their accumulation
• 30 per cent of employees take two days of accumulated sick leave in years subsequent to
their accumulation.
Assume that the average annual salary per employee is $40 000 and that employees have a
five‑day working week.
(a) Measure the nominal amount of the provision for sick leave as at 30 June 20X6 in accordance
with IAS 19.
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(b) Explain whether it is important to know the timing of the payments to employees for
accumulated sick leave in future reporting periods.
Long-term employee benefits

As a result of providing services during a particular reporting period, employees may receive
benefits several years later. These benefits may be settled:
• while the employee is still employed or upon resignation (e.g. LSL), or
• subsequent to the employee’s employment (e.g. superannuation benefits and other
post‑employment benefits).
This module focuses on LSL to illustrate the application of measurement principles and
techniques to long-term employee benefits.
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Long service leave

In some countries, including Australia, LSL is another entitlement that accrues to employees as
they provide services to an entity. This entitlement accrues with years of service. Under some
industrial laws and employment contracts, employees are legally entitled to be paid LSL after
a certain number of years’ service have been completed (10 years is a typical benchmark).
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LSL should be recognised as a liability, once the definition of liability has been satisfied.
In the past, some entities only recognised a liability or expense for LSL when employees became
legally entitled to LSL—that is, when the leave became vested. In effect, employees who were
not legally entitled were excluded in measuring the liability. However, consistent with the
Conceptual Framework’s broader definition of a liability, IAS 19 is based on the view that the
definition of a liability or expense is satisfied as soon as employees provide services that result
in LSL entitlements. This is so, irrespective of whether the employee is legally entitled to LSL.
LSL benefits are paid in reporting periods after the employees’ provision of services, often many
years into the future. Paragraph 155 of IAS 19 requires the amount of the liability for such
long-term employee benefits to be measured on a net basis as the PV of the obligation at the
reporting date (see paras 56–98) minus the fair value at the reporting date of plan assets (if any)
out of which the obligations are to be settled directly (see paras 113–19).
Entities estimate the number of employees who may become eligible for LSL, as well as the
timing and amount of the payment. Projected salary levels (e.g. inflation, salary increase and
promotions) need to be factored into the calculation. The estimated LSL payment is discounted
to its PV at the reporting date.
In Australia, it would be rare for entities to hold assets in a long-term employee benefit fund
to satisfy LSL obligations. Therefore, this module focuses on the determination of the PV of
the obligation.
In essence, the Projected Unit Credit Method determines the accumulated entitlement for
service on the basis of the ratio of the period of service completed up to the reporting date,
to the periods of service required to accumulate the total entitlement. For example, if an
employee has served eight of the 10 years required for entitlement to LSL, the accumulated
entitlement would be 80 per cent of the total under the Projected Unit Credit Method.
Determination of the timing and amount of future cash flows requires professional judgment and
is often based on actuarial assessment.
If you wish to explore this topic further, read paras 56–69 of IAS 19, which describe and provide
examples of the Projected Unit Credit Method used to measure long-term employee benefits.
Many employees of an entity will have an insufficient length of service to be legally entitled to an
LSL payment at the reporting date. Nevertheless, a proportion of employees in this category will
eventually qualify for LSL. As a result, a probability assessment must be undertaken to estimate
the number of employees currently in this situation who will eventually be paid for LSL. IAS 19
provides no guidance on this matter, leaving it to the preparer’s judgment.
Once the number of employees who will be paid LSL has been determined, the next task is
to determine the timing and amount of the payments that will result from services provided
up to the reporting date. To determine the future cash flows associated with LSL benefits,
projected annual salary levels must be estimated. The estimation of projected salaries is affected
by the expected timing of payment of LSL and involves consideration of factors such as inflation
and promotions.
The estimated future LSL payments must be discounted to PV at the reporting date. The interest
rate used will have a significant effect on the measurement of an employer’s obligation for LSL.
This objective is reflected in the IAS 19 Employee Benefits requirement that the discount rate
used to measure LSL liabilities should be determined by reference to current market yields on
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high-quality corporate bonds. In currencies with no deep market for high-quality corporate
bonds, the interest rates attaching to government bonds must be used (IAS 19, para. 83).
It should be noted that entities operating in different countries will have to select discount
rates appropriate to the country in which the employee will be paid.
➤➤Question 1.13
At 30 June 20X7, Maynot Ltd has 100 employees. For simplicity, assume that the employees
have the following periods of service:
Years of service Number of employees
2 10
4 40
8 30
10 10
15 10
100
The employees of Maynot Ltd are employed under an award that provides for LSL on the
basis of 90 calendar days after 13 years of service and nine days per year of service thereafter.
After 10 years of service, employees are entitled to a pro rata payment if they resign or their
employment is terminated.
Outline the steps that you would need to take and the factors that you would need to consider
in determining Maynot Ltd’s liability for LSL.
Example 1.8 builds on the data in Question 1.13.

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Example 1.8: Probability of entitlement to long service leave

The following estimates of the likelihood that employees of Maynot Ltd will eventually take leave have
been determined by an actuary:
Probability that an employee
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Years of will become entitled to
service LSL payments
1 0.20
2 0.20
3 0.25
4 0.40
5 0.40
6 0.70
7 0.75
8 0.90
9 0.95
10 1.00
As would be expected, the closer the employee is to completing the pre-entitlement period, the higher
is the probability of payment. From the above calculations, it has been estimated that there is a
70 per cent probability that an employee with six years of service will be employed for 10 or more
years and will therefore become entitled to LSL. After nine years of service, it is estimated that there
is a 95 per cent probability that the employee will become entitled.
Based on the preceding probabilities, it can be estimated that, as at 30 June 20X7, the following
number of employees will eventually be eligible for LSL:
Estimated number of
Years of Number of employees who will
service employees Probability become entitled to LSL
2 10 0.2 2
4 40 0.4 16
8 30 0.9 27
10 10 1.0 10
15 10 1.0 10
100 65
Note: Only the probabilities applicable to the current employees are used.
The next task is to determine the future payments for services performed up to the end of the reporting
period that will be made to the 65 employees who, it is estimated, will receive LSL pay. This amount
will depend on projected future wages and salaries, as well as experience with employee departures
and periods of service. It is also necessary to make assumptions about when the leave will be taken,
so that the time to settlement can be taken into account in measuring the present value (PV) of the
obligation. Employees do not necessarily take LSL as soon as they become unconditionally entitled
to do so. Some employees may be paid LSL before they become fully entitled where the employment
contract or legal environment allows for leave to be paid on a pro rata basis if they resign or if the
employment is terminated. Again, experience with leave patterns will be a factor in estimating when
LSL obligations will be settled.
Assume that the actuary has estimated that the employees who will become entitled to LSL will be
paid the following amounts in the following periods:
Years from Number of Amount expected

30 June 20X7 employees to be paid $
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2 15 120 000
5 20 200 000
10 20 300 000
15 10 200 000
65 820 000
The final issue is to determine appropriate discount rates to measure the payments at their PV.
This would involve selecting high-quality corporate bond rates with terms to maturity that match the
terms of the estimated cash payments. Again, for illustrative purposes, the discount rates in the second
column below could have been made for Maynot Ltd. Each discount rate is used to determine the
relevant PV factor from the tables below. For example, a discount rate of 8 per cent for an amount
payable in two years time is 0.85734. The amount expected to be paid in the future is multiplied by
the PV factor to calculate the present value of the liability at the current reporting date. From the
calculations below, an amount of $120 000 payable in two years time at a discount rate of 8 per cent
has a present value of $102 881.
Years from Discount Amount expected Present Present

30 June 20X7 rate† to be paid $ value factor‡ value $
2 0.08 120 000 0.85734 102 881
5 0.09 200 000 0.64993 129 986
10 0.10 300 000 0.38554 115 662
15 0.10 200 000 0.23939 47 878
820 000 396 407

†
These discount rates are illustrative market yields on high-quality corporate bonds for the appropriate term.

‡
The PV factor is determined by using the discount rate indicated and the number of years to the payment.
This can be found in PV tables (extract shown below) or calculated using the following formula: 1 / (1 + r)n,
where r is the interest rate and n is the number of periods to settlement.
Therefore, Maynot Ltd would recognise a liability for LSL of $396 407 as at 30 June 20X7.
The following is an extract of PV tables for a lump sum payment:
Period 8% 9% 10%
1 0.92593 0.91743 0.90909
2 0.85734 0.84168 0.82645
3 0.79383 0.77218 0.75131
4 0.73503 0.70843 0.68301
5 0.68058 0.64993 0.62092
6 0.63017 0.59627 0.56447
7 0.58349 0.54703 0.51316
8 0.54027 0.50187 0.46651
9 0.50025 0.46043 0.42410
10 0.46319 0.42241 0.38554
11 0.42888 0.38753 0.35049
12 0.39711 0.35553 0.31863
13 0.36770 0.32618 0.28966
14 0.34046 0.29925 0.26333
15 0.31524 0.27454 0.23939

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

Share-based payments provide an interesting illustration of the difficulty of fair value
measurement and its implications. Accounting for share-based payments falls within the scope
of IFRS 2 Share-based Payment.
A share-based payment transaction is:

a transaction in which the entity
(a) receives goods or services from the supplier of those goods or services (including an
employee) in a share-based payment arrangement, or
(b) incurs an obligation to settle the transaction with the supplier in a share-based payment
arrangement when another group entity receives those goods or services (IFRS 2,
Appendix A).
Share-based payment transactions may be cash-settled or equity-settled.
In a cash-settled share-based payment transaction, the entity acquires goods or services by

incurring a liability to transfer cash or other assets, the amount of which is based on the price
of the entity’s equity instruments (IFRS 2, Appendix A). For example, an entity might agree to
pay a cash bonus for employees’ services of 100 times the company’s share price. A transaction
may therefore be a share-based transaction even though there is no exchange of the entity’s
equity instruments.
In an equity-settled share-based payment transaction, the entity acquires goods or services

as consideration for its own equity instruments, or it receives goods or services but has no
obligation to settle the transaction with the supplier (IFRS 2, Appendix A). Examples include
employee shares and executive stock options.
Goods or services acquired in a share-based payment transaction are recognised when the
goods are obtained or the services are received (IFRS 2, para. 7). For an equity-settled share-
based payment transaction, a corresponding increase in equity is recognised. For a cash-settled
share-based payment transaction, a corresponding increase in a liability is recognised.
If you wish to explore this topic further, read paras 7–9 of IFRS 2. The definitions of terms used
in the standard are provided in IFRS 2, Appendix A.
Example 1.9: Performance bonuses

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

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

corresponding increase in equity being recognised when the employee service was received.
The pro forma entry for the other executives’ bonuses at 30 June 20X9 was:
Dr Bonus expense XXX

Cr Liability XXX
The cash-settled share-based payment transaction resulted in an increase in expenses and a

corresponding increase in liabilities being recognised when the employee service was received.
Measurement of share-based payment transactions

Share-based payment transactions are measured as follows:
• Equity-settled
–– Measure the goods or services received and the corresponding increase in equity at the
fair value of the goods or services received, provided that the fair value can be estimated
reliably. This is referred to as directly measuring the goods and services.
–– In some cases, the fair value of the goods or services received cannot be estimated
reliably, such as for transactions with employees and others providing similar services.
Under these circumstances, the fair value of the goods or services and the corresponding
increase in equity are measured indirectly, with reference to the fair value of the equity
instruments granted.
• Cash-settled
–– Measure the goods or services received and the liability incurred at the fair value of
the liability.
–– Until the liability is settled, it may be re-measured at the end of each reporting period
and upon settlement, with changes in the fair value of the liability recognised in P&L.
In the case of equity-settled share-based payment transactions, the fair value of the goods or
services acquired drives the measurement of equity, consistent with equity being the residual
element in the statement of financial position (i.e. the difference between assets and liabilities).
However, if the fair value of the goods or services acquired cannot be measured reliably, IFRS 2
departs from this approach and requires indirect measurement based on the fair value of the
equity instruments (IFRS 2, para. 10).
If you wish to explore this topic further, read paras 10–13A and 30–3 of IFRS 2.
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Investment property
Investment property applies a mixed measurement model based on the purpose and nature
of the asset. An entity may:
(a) choose either the fair value model or the cost model for all investment property backing
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liabilities that pay a return linked directly to the fair value of … specified assets including that
investment property; and
(b) choose either the fair value model or the cost model for all other investment property,
regardless of the choice made in (a) (IAS 40, para. 32A)
Both measurement bases applied in IAS 40 Investment Property provide valuable information
based on the different fundamental qualitative characteristics. For example, the cost model
provides faithful representation but would, arguably, be less relevant in future reporting periods.
The fair value model provides the reverse relationship. This points to the difficulty of determining
an appropriate measurement basis for assets to provide useful financial information.
Investment property is defined in IAS 40, para. 5, as:

property (land or a building—or part of a building—or both) held (by the owner or by the lessee
as a right-of-use asset) to earn rentals or for capital appreciation or both, rather than for:
(a) use in the production or supply of goods or services or for administrative purposes; or
(b) sale in the ordinary course of business.
Examples of investment property described in IAS 40, para. 8, are:

land held for long-term capital appreciation rather than for short-term sale in the ordinary course
of business;
land held for a currently undetermined future use …;
a building owned by the entity (or a right-of-use asset relating to a building held by the entity)
and leased out under one or more operating leases;
a building that is vacant but is held to be leased out under one or more operating leases; and
property that is being constructed or developed for future use as investment property.
IAS 40 specifies the accounting for investment property as distinct from property, plant and
equipment accounted for in accordance with IAS 16 Property Plant and Equipment—property,
plant and equipment being tangible assets that are used by an entity in the ‘production or supply
of good or services, for rental to others, or for administrative purposes’ (para. 6).
IAS 16 permits an entity to choose either the cost model or the revaluation model for property,
plant and equipment after the asset’s initial recognition. Where the revaluation model is the
accounting policy, the increase in the asset’s carrying amount is recognised in OCI and is
accumulated in equity. A decrease in the carrying amount (not reversing a previous increase)
is recognised in P&L in a similar manner to the investment property. To provide some consistency
in the measurement, IAS 16 requires the choice of measurement basis (i.e. cost model or
revaluation model) to be applied across a class of assets.
IAS 40 also allows entities to carry their investment properties at either cost or fair value
(IAS 40, para. 30). Similarly to IAS 16, the accounting policy choice must be applied to a class
of investment properties. The fair value model results in the gains or losses arising from a change
in the fair value of investment property being recognised in P&L in the period in which it arises
(IAS 40, para. 35).
If you wish to explore this topic further, read paras 30–35 of IAS 40.
One of the enhancing qualitative characteristics in the Conceptual Framework is comparability.

Comparability refers to information as being more useful if it can be compared with similar
information about other entities and with similar information about the same entity for a
comparable reporting period.
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The accounting policy choice provided in IAS 40 in relation to the measurement of investment
properties is arguably inconsistent with the qualitative characteristic of comparability, as some
entities will measure investment properties at cost, whereas other entities will measure
investment properties at fair value. The cost and fair value of an investment property could
be materially different.
The need for consistent information is addressed by requiring entities that choose to hold their
investment properties at cost to disclose the fair value of the investment properties in the notes
to the financial statements (IFRS 40, para. 79(e)). This requirement helps to ensure that users have
access to comparable information.
Another measurement issue arises with the recognition of fair value movements on investment
property through P&L. Valid questions are often raised about whether these unrealised gains
(which adjust the carrying amount of the investment property) satisfy the definition and
recognition criteria for an ‘asset’ in the Conceptual Framework. Questions may be raised about
whether it is probable that the economic benefits will flow to the entity because these gains may
be reversed before the asset is realised.
Furthermore, the usefulness of showing unrealised movements through P&L can be challenged,
as the result for the year is affected by fair value movements caused by factors external to the
entity (e.g. market and economic factors) rather than by the entity’s operational performance.
Therefore, an entity’s financial performance does not necessarily show the results of its
operating activities.
Professional judgment
Financial reporting is not just a mechanical practice based on following specified rules. It is
focused on meeting an important objective, and this requires careful thought and professional
judgment when deciding how to deal with particular items. Instead of a checklist approach,
judgment is required to evaluate whether the overarching objective is being met in the
most appropriate way. An example of the application of judgment includes determining
the materiality of particular items.
Professional judgment is an important characteristic of professional practice. It requires a

combination of conceptual and practical knowledge and is described as the ability to diagnose
and solve complex, unstructured values-based problems of the kind that arise in professional
practice (Becker 1982). Professionals are expected to make decisions based on an objective
review of the relevant data rather than on a choice of outcomes that suit the employer or
client. Professional judgment may often involve making a trade-off between relevance and
faithful representation, which are two qualitative characteristics that accounting information
should possess.
The selection and application of accounting policies, and the recording and communication of
financial information based on these decisions, are essential functions that require professional
judgment. West (2003) suggests that without judgment, accounting becomes nothing more than
a book of rules for compliance.
In general, the IFRSs reflect a principles-based approach rather than very specific rules about
what must be done. This provides significant scope for the exercise of judgment in the
application of principles to specific situations.
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The Conceptual Framework and IFRSs have not been developed with the intention of eliminating
professional judgment. What frameworks do in this context is provide a coherent set of objectives,
assumptions, principles and concepts within which those judgments are made.
Accounting standards provide the principles that an entity needs to apply, but they do not
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provide all of the answers as to how to apply them. For example, in accordance with IAS 16
Property, Plant and Equipment, an entity is required to write off the cost of an asset over its
useful life. Determining what the useful life is requires professional judgment. Another example
is found in IFRS 7 Financial Instruments: Disclosures, which indicates that the identification
of concentrations of risk in relation to financial instruments requires judgment that takes into
account the circumstances of the entity (para. B8).
Applying professional judgment to estimates and accounting policy

Professional judgment is particularly important in making estimates and in developing
accounting policies. In many circumstances, the exact amounts to be disclosed in the financial
statements cannot be able to be determined, and therefore, estimates are required. This is
acknowledged in para. OB11 of the Conceptual Framework, which states that ‘to a large extent,
financial reports are based on estimates, judgments and models rather than exact depictions’.
The combination of professional judgment and a disciplined approach to estimation ensures

that the information provided is still relevant and reliable (IAS 8, paras 8 and 10). This is also
acknowledged in the Conceptual Framework’s discussion on faithful representation, which
suggests that a representation of an estimate:
can be faithful if the amount is described clearly and accurately as being an estimate, the nature
and limitations of the estimating process are explained, and no errors have been made in selecting
and applying an appropriate process for developing the estimate (para. QC15).
Paragraph QC26 also allows for a range of probability estimates to be provided, rather than a
single amount, and to be regarded as verifiable.
It is important that the choice of accounting policies is aligned with estimates that are focused
on providing the most accurate and faithful representation of the organisation. There may be a
temptation to select accounting policies or estimates that provide a particular viewpoint of the
organisation, but professional judgment and ethics must ensure that the selection made is
the most suitable.
Preparers of financial reports need to refer to the Conceptual Framework when developing
accounting policies and estimates for which no specific accounting standard exists (IAS 8,
para. 10), such as when assessing whether a transaction should be expensed or capitalised
and determining the timing of recognition of certain transactions.
Disclosures
This module concludes by briefly considering the role of disclosures and how to determine when
disclosures are required. This provides a clear link to Module 2, which focuses on the presentation
of the financial statements, including the disclosures required for each financial statement.
Effective disclosures play an important role in helping the decision-making of users. Entities need
to ensure that their financial reporting disclosures are clear and effective in informing users as to
the entity’s performance during the year, as well as its financial position. Simply providing more
information to users is not sufficient to meet user needs, as disclosure overload is a concern
for many users.
The role and purpose of disclosures

‘Disclosure’ is a broad term and refers to items presented in the financial statements and in items
disclosed in the notes to the financial statements (IAS 1, para. 47). The role of these disclosures is
linked to the objective of financial reporting, which is to provide an account of the organisation
so that users have useful information with which to guide their decision-making. The focus on
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disclosures transitions from the theoretical discussion found in the Conceptual Framework to
Module 2 and how financial statements are presented. The primary financial statements on
their own are not sufficient for users to be able to make informed decisions. Disclosures provide
additional information and explanations to assist users in understanding the financial statements.
Criteria for determining whether disclosure is required

Disclosure is included in financial statements in accordance with the disclosure requirements of
the accounting standards. These are often linked to the definitions and recognition criteria that are
discussed throughout this module. In addition, IAS 1 Presentation of Financial Statements, para. 15,
notes that compliance with the IFRSs, with additional disclosures when necessary, is presumed to
result in the fair presentation of the financial statements. This is further expanded upon in IAS 1,
para. 17:
In virtually all circumstances, an entity achieves a fair presentation by compliance with applicable
IFRSs. A fair presentation also requires an entity:
(a) to select and apply accounting policies in accordance with IAS 8 Accounting Policies, Changes
in Accounting Estimates and Errors. IAS 8 sets out a hierarchy of authoritative guidance that
management considers in the absence of an IFRS that specifically applies to an item;
(b) to present information, including accounting policies, in a manner that provides relevant,
reliable, comparable and understandable information; and
(c) to provide additional disclosures when compliance with the specific requirements in IFRSs is
insufficient to enable users to understand the impact of particular transactions, other events
and conditions on the entity’s financial position and financial performance.
Management may believe that compliance with a specific requirement in an IFRS would be
very misleading. If the item is believed to be so misleading that it would conflict with the
overall objective of financial statements, the entity may depart from that requirement—that is,
it may account for it in a different manner. This departure is only permitted if the legal rules in
that country or jurisdiction allow it (IAS 1, para. 19). This situation is only considered to arise
in extremely rare circumstances, and there are specific disclosure obligations if an entity should
consider this departure to be appropriate (para. 20). It should be noted that, in Australia,
the following types of entities are prohibited from such departures from a requirement in an
accounting standard:
• entities for which the Corporations Act applies
• not-for-profit entities
• entities for which the reduced disclosure requirements apply (AASB101 para. Aus19.1).
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The importance of a consistent approach to disclosure

A consistent approach to disclosure can be clearly linked back to the Conceptual Framework’s
qualitative requirements of comparability and understandability.
Accounting provides powerful and useful information that can highlight managers’ poor
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performance and stewardship. Organisations facing difficulty may be tempted to mask
poor results by providing information in a manner that is not easily interpreted or analysed.
One method that may cause confusion involves formally disclosing all relevant items but
in such a manner that they are not easily compared to previous periods or able to be
properly understood.
This type of disclosure goes against the requirements of fair presentation and hinders the
usefulness of accounting information. A consistent approach to disclosure must therefore be
maintained, and any deviations should be clearly justified and carefully explained.
Review
This module explained the role and importance of financial reporting as a communication tool for
entities to provide information to users to help with decision-making. It discussed how financial
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reports are accessed by a broad range of users, including shareholders, banks, competitors,
employees and financial analysts. It also considered the importance of an internationally
accepted conceptual framework in creating financial reports that meet the information needs
of users.
The use of accounting standards as a consistent language for reporting enables financial
statements to be prepared that users will understand and be able to compare between entities.
The IFRSs are the global language of accounting standards. This module considered the role
and importance of financial reporting for users and discussed the application of reporting in
an international context. It then discussed the need for GPFSs, the role that the Conceptual
Framework plays in financial reporting and the limitations of frameworks.
A conceptual framework plays a key role in assisting users in their decision-making by providing
consistency in the development of accounting standards and in providing a common set
of definitions, recognition principles and measurement principles. These act as a guide in
accounting for transactions not covered by accounting standards, including emerging financial
reporting issues. A conceptual framework also provides a source of legitimacy to the standard-
setting process and enhances the consistency of accounting standards. These benefits are
subject to the economic, legal, social and political constraints that apply to conceptual
frameworks. Furthermore, there is a continuing need for professional judgment in accounting.
In this module, the IASB’s Conceptual Framework for Financial Reporting was analysed.
The major components of the Conceptual Framework, including the qualitative characteristics
of useful financial information and the elements of financial statements, were examined.
This module also discussed the different approaches to measuring the elements of financial
statements and applying the measurement bases to the measurement of liabilities and expenses
for leases, employee benefits, share-based payments and investment property.
The module concluded with a consideration of the purpose of disclosure to help meet the
decision-making needs of users. This discussion also provided a link to the Module 2 discussion
of presentation of financial statements.
Suggested answers | 77
Suggested answers
MODULE 1
Suggested answers
Question 1.1
According to para. OB5 of the Conceptual Framework, the primary users of general purpose
financial reports are existing and potential investors, lenders and other creditors who do not have
the ability to require a reporting entity to provide information. As such, they rely on the general
purpose financial reports for information.
Other users may find the reports useful, but these reports are not specifically directed at them.
This includes management (who can obtain information internally), regulators and members of
the general public (Conceptual Framework, paras OB9 & OB10).
Return to Question 1.1 to continue reading.
Question 1.2
The focus of financial reporting is on the information needs of primary users, but this does not
mean that financial reports will be irrelevant to other users. Although the reports may not be
specifically tailored to meet their needs, other parties, such as regulators and members of the
public, may find general purpose financial reports useful (Conceptual Framework, para. OB10).
One reason for this is that the information needs of primary users and other groups of users
overlap. For example, customers of a construction company may need information about
cash flows, sources of funds and risk to assess whether the company is likely to continue its
operations. This may help them to decide whether to trust the construction company with a
long-term project. They would not wish to hire a company to do a job that it could not complete.
Similarly, investors and creditors need information about cash flows, sources of funds and risk to
assess the long-term viability of the construction company.

Question 1.3
The decision-usefulness objective of financial reporting provides some guidance to standard
setters because it provides the underlying purpose that should be served in making deliberations
about accounting standards. That is, the standard setters should seek to determine what types
MODULE 1
of information are most useful for decisions made by users of financial statements. However,
the decision-usefulness objective fails to provide unambiguous guidance in solving financial
reporting problems, because any evaluation of the usefulness of items of information to users
is biased by their familiarity with the information. It is difficult to find evidence of the usefulness
of information that is not available. Also, decision-usefulness may vary between users because
they make different types of decisions, such as whether to sell their shares or whether to
extend credit. Even for similar decisions, users may use different decision-making models,
giving rise to different information needs. Finally, the decision-usefulness objective is capable
of multiple interpretations and has been used to support a variety of measurement approaches
in accounting standards.
Question 1.4
Alternative measures of profit of Tower Ltd for the first year of operations:
Cash basis Accrual basis

$ $
Sales 37 000 40 000
Cost of goods sold (50 000 ) (30 000 )
Insurance expense (4 000 ) (1 000 )
Profit (loss) for the year (17 000 ) 9 000
The accrual basis includes all of the sales revenue generated during the period, whereas under
the cash basis, revenue is recognised when cash is received. Thus, the uncollected credit sales
of $3000 at the end of the period are excluded. If the accounts receivable are collected in the
following year, they will be included in the sales revenue for that year under the cash basis.
Another difference between the two measures of profit is that the accrual basis determines
cost of sales as the cost of inventory that has been consumed during the period. Accordingly,
under the accrual basis of accounting, cost of sales includes the cost of widgets to the extent
that they have been sold, whereas the widgets on hand at the end of the period are recognised
as an asset. In contrast, all payments for the acquisition of inventory are included as cost of sales
using the cash basis.
Under the accrual basis of accounting, the expenditure on the insurance premium is recognised
as an expense to the extent that it relates to the current period. In this case, 25 per cent of the
insurance premium is recognised as an expense because three months of the 12-month period
covered by the insurance contract have expired. The unexpired portion of the premium is
75 per cent because there are nine months remaining of the 12-month contract. The insurance
premium is recognised as an asset (prepaid insurance) to the extent that it relates to a period of
insurance cover that remains unexpired at the end of the reporting period. In contrast, under the
cash basis of accounting, the entire insurance premium is recognised as an expense in the period
in which the payment is made.
The accrual basis provides more useful information about the performance of the entity because
it compares revenue with expenses incurred in the same period. Further, under the accrual basis
of accounting, assets are recognised when expenditure results in future economic benefits that
are expected to flow to the entity. For example, the accrual basis recognises that Tower Ltd has
a resource, namely inventory, from which it expects to obtain future cash inflows through sale.
MODULE 1
The prepaid insurance premium represents future economic benefits because Tower Ltd will be
covered for property losses arising from fire or theft during the next nine months.
An understanding of accrual accounting and why the recognition of income and expenses
does not always coincide with the receipt and payment of cash is assumed knowledge in the
Financial Reporting subject. If you have found the calculations and reasoning in the answer to
this question to be challenging, it is recommended that you revise balance day adjustments and
the basics of calculation of cash flows from an introductory financial accounting textbook before
attempting Module 2 of this subject.
Question 1.5
The purpose of this question is to help you to appreciate the role of professional judgment
in applying principles such as the fundamental qualitative characteristics. Answers may vary
depending on what type of information is suggested as being most relevant to users’ decision-
making processes. The following suggested answer should not be viewed as a unique solution
to the problem.
(a) The market value of the emission trading allowances is tentatively suggested as the most
relevant type of information about the phenomenon.
(b) Market value might be assumed to be available and as being able to be represented
faithfully. If this is the case, it should be used. However, if it is assumed that the available
market value is not from an active market, it could be concluded that the market value
cannot be represented faithfully. A reason for this is that it might be necessary to make
some adjustments to the most recently traded price to estimate a current market value.
Accordingly, an alternative type of information, such as the cost of the emission trading
allowances or their market value at the time they were acquired, might be used if
Coalite Ltd had received them as a government grant.
Question 1.6
IFRS 13 applies comparability by establishing a single definition of fair value and hierarchy for
its measurement instead of having different definitions and measurement frameworks within
the IFRSs.
The standard applies verifiability by identifying a quoted price, which is directly verifiable, as the
preferred measurement. Similarly, a Level 2 estimation model that has no significant unobservable
inputs is preferred over a Level 3 estimation model, which includes some significant unobservable
inputs. Some aspects of Level 3 measurements can be verified, including processes such as
calculations used in applying the model and any observable inputs.

Question 1.7
Subsequent measurement of the Sydney Harbour Bridge at the AUD equivalent of its historical
cost could have implications for the decision-usefulness of the statement of financial position
because the historical cost of the bridge is merely a historical record of the financial sacrifice
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made to construct it. The historical cost, particularly one incurred so long ago, is not a relevant
measure of the future economic benefits expected to be derived from using the bridge.
There may also be implications for the comparability of financial statements that recognise
this asset because the financial statements may include costs relating to assets acquired
at different times. The Sydney Harbour Bridge, reported at its historical cost equivalent of
AUD 13.5 million, could be recognised at a lower value than other, more recently constructed
assets and, in accounting terms, may be immaterial in size. Further, ratios could be distorted by
the comparison of current income with a historical cost, in the light of changes in the purchasing
power of currency since 1932.
In this regard, historical cost has been criticised on the grounds that it aggregates costs incurred
at various times as though they are equivalent in economic terms. However, allowing for the time
value of money, the presumption is open to criticism.
In summary, the question highlights one of the major deficiencies of historical cost—that is,
with the passage of time historical costs become dated and, therefore, have limited relevance
to decision-making.
Question 1.8
The measurement technique for the Alpha B shares uses Level 2 inputs because their measurement
was based on a similar security in an active market, the Alpha A shares. It is not Level 1 because the
observed price is not for an identical security. The Alpha B preference shares held by Stanley Ltd
are unlisted and have a different coupon rate.
Question 1.9
Current cost could provide more decision-useful information because it is based on the amount
of cash or cash equivalents that would be required currently to acquire (or construct) the asset,
which may be considered more relevant than historical cost.
This information may also be considered to be more comparable because the financial statements
that include current cost relating to assets will be measured at the same time, rather than at
different times. In that way, the Sydney Harbour Bridge reported at a current cost would be
recognised at a value that has the same basis as any other bridge constructed at a later time.

Question 1.10
The journal entries to be recorded by the lessee (B Ltd) throughout the term of the lease are
as follows.
MODULE 1
Year ended 30 June 20X4
30.06.X4 Dr Cr
Right-of-use vehicle 67 813
Lease liability 49 813
Prepaid executory costs† 1 800
Cash 19 800
(Initial recording of lease asset/liability)

01.07.X4 Dr Cr
Executory costs 1 800
Prepaid executory costs 1 800
(Reversal of prepayment)
30.06.X5
Interest expense 4 483
Cash 19 800
(Second lease payment)
Depreciation expense 15 453

Accumulated depreciation 15 453
(Depreciation charge for the period ($67 813 – $6 000) / 4)

01.07.X5 Dr Cr
30.06.X6
Cash 19 800
(Third lease payment)

(Depreciation charge for the period)

01.07.X6 Dr Cr
MODULE 1
30.06.X7
Cash 19 800
(Fourth lease payment)

(Depreciation charge for the period)

01.07.X7 Dr Cr
30.06.X8
Interest expense 496
Cash 6 000
(Return of leased vehicle)

(Depreciation charge for the period—
rounding adjusted in final year)

Right-of-use vehicle 61 813
†
Prepaid costs: because the benefits of insurance and maintenance will not be received until
following period.

Question 1.11
The journal entries to be recorded by the lessor (A Ltd) throughout the term of the finance lease
are as follows.
MODULE 1
30.06.X4 Dr Cr
Motor vehicle 68 000
Cash 68 000
(Purchase of motor vehicle)
Lease receivable 68 000

(Lease of motor vehicle)

Cash 2 647
(Payment of initial direct costs)
Cash 19 800
Reimbursement in advance† 1 800
(Receipt of 1st lease payment)

01.07.X4 Dr Cr
Reimbursement in advance 1 800
Reimbursement revenue 1 800
(Reversal of accrual)
30.06.X5
Insurance and maintenance expenses 1 800
Cash 1 800
(Payment of costs on behalf of lessee)
Cash 19 800
Interest revenue 4 738
(Receipt of 2nd lease payment)

01.07.X5 Dr Cr
MODULE 1
30.06.X6
Cash 1 800
Cash 19 800
(Receipt of third lease payment)

01.07.X6 Dr Cr
30.06.X7
Cash 1 800
Cash 19 800
(Receipt of third lease payment)

01.07.X7 Dr Cr
30.06.X8
Cash 1 800

Interest revenue 826
(Return of vehicle at end of lease)
†
Reimbursement of executory costs are carried over to the next period when they will be paid by the lessor.

Question 1.12
(a) At 30 June 20X6, 20 per cent of the entity’s employees had taken their full entitlement of
sick leave during the year. The remaining 80 per cent of employees have an average of
12 days accumulated sick leave. If the provision for sick leave was based on the average
MODULE 1
number of accumulated days per employee then the provision would be calculated using
a total of 4800 days (500 employees × 80% × 12 days). However, the provision for sick leave
should be based on payments ‘expected’ to be paid to employees in the short-term (IAS 19,
paras 11–14). Therefore, the provision for sick leave should be calculated using data on the
past experience of employees taking accumulated sick leave. This is calculated as follows:

Number of Number of sick
employees days expected Total number
expected to to be taken of sick leave
Total employees % take sick leave per employee days expected
500 50% 250 6 1 500
500 30% 150 2 300
1 800
Given an average annual salary per employee of $40 000 and a five-day working week,
the payment per sick day would be: $40 000 / 260 = $153.85 (5 days × 52 weeks =
260 working days per year).
Therefore, the amount of the provision for sick leave:

= Total expected number of days of sick leave × Payment per sick day
= 1800 × $153.85
= $276 930
(b) The expected timing of payments is important in determining how the liability should be
measured. The liability for sick leave that the entity expected to settle within 12 months
after the reporting period is measured at the nominal amount. Liabilities for compensated
absences expected to be settled beyond 12 months after the period are measured using
PV techniques in accordance with IAS 19 Employee Benefits.
Question 1.13
To determine the amount of LSL for Maynot Ltd, it is first necessary to determine those
employees who will become entitled to receive a payment as a result of services provided up
to the reporting date. All employees with 10 or more years of service are currently entitled to
a payment. Although Maynot Ltd has 80 employees who are currently not entitled to LSL at
30 June 20X7, some will eventually be paid LSL for services that they have already provided.
Therefore, the first issue to assess is the probability of those employees not currently entitled to
LSL actually receiving a payment for LSL. This assessment would be based on past data either
for the whole entity or for groups of employees where, for example, staff turnover rates may
vary between different groups of employees.

MODULE 1
References | 87
References
MODULE 1
References
AARF & ASRB (Australian Accounting Research Foundation & Accounting Standards Review
Board) 1990, Statement of Accounting Concepts 1 (SAC 1): Definition of the Reporting Entity,
AARF and ASRB, Melbourne, accessed September 2016, http://www.aasb.gov.au/admin/file/
content102/c3/SAC1_8-90_2001V.pdf.
AASB (Australian Accounting Standards Board) 2017a, ‘Frequently asked questions’, accessed
November 2017, http://www.aasb.gov.au/About-the-AASB/Frequently-asked-questions.aspx.
AASB (Australian Accounting Standards Board) 2017b, ‘Reduced disclosure requirements’,

accessed November 2017, http://www.aasb.gov.au/Work-In-Progress/Reduced-Disclosure-
Requirements.aspx.
AASB (Australian Accounting Standards Board) 2017c, ‘Tier 2 requirements’, accessed November
2017, http://www.aasb.gov.au/Work-In-Progress/Reduced-Disclosure-Requirements/Tier-2-
Requirements.aspx.
Becker, E. A. 1982, ‘Is public accounting a profession?’, The Woman CPA, vol. 44, no. 4, pp. 2–4.
FRC (Financial Reporting Council) 2017, ‘Financial Reporting Lab’, accessed November 2017,
https://www.frc.org.uk/Our-Work/Codes-Standards/Financial-Reporting-Lab.aspx.
IASB (International Accounting Standards Board) 2005, Measurement Bases for Financial
Reporting—Measurement on Initial Recognition, International Accounting Standards Committee
Foundation, London.
IFRS Foundation 2016a, ‘IASB Chairman to prioritise communication effectiveness of financial

statements during second term’, 30 June, accessed November 2017, http://www.ifrs.org/news-
and-events/2016/06/iasb-chairman-prioritises-communication-in-financial-statements.
IFRS Foundation 2016b, Better communication, 30 June, accessed June 2017, http://www.ifrs.
org/-/media/feature/news/2016/june/hans-hoogervorst-zurich-conference-2016.pdf.
IFRS Foundation 2017a, ‘Why global accounting standards?’, accessed November 2017,
http://www.ifrs.org/use-around-the-world/why-global-accounting-standards.
IFRS Foundation 2017b, ‘Who uses IFRS Standards?’, accessed November 2017, http://www.ifrs.
org/use-around-the-world/use-of-ifrs-standards-by-jurisdiction/.
IFRS Foundation 2017c, ‘The IFRS for SMEs Standard’, accessed November 2017, http://www.ifrs.
org/IFRS-for-SMEs/Pages/IFRS-for-SMEs.aspx.
MODULE 1
IFRS Foundation 2017d, ‘Principles of Disclosure’, accessed November 2017, http://www.ifrs.org/

projects/work-plan/principles-of-disclosure/.
IFRS Foundation 2017e, ‘Discussion Paper and comment letters—Disclosure Initiative—Principles

of Disclosure’, accessed November 2017, http://www.ifrs.org/projects/work-plan/principles-of-
disclosure/comment-letters-projects/dp-principles-of-disclosure/.
Kivumbi 2010, ‘Difference between IAS and IFRS’, accessed November 2017, http://www.
differencebetween.net/business/difference-between-ias-and-ifrs/.
SEC (Securities and Exchange Commission) 2007, ‘Acceptance from foreign private issuers of
financial statements prepared in accordance with international financial reporting standards
without reconciliation to U.S.’ GAAP, Release Nos. 33-8879; 34-57026; International Series Release
No. 1306; File No. S7-13-07, December, accessed November 2016, https://www.sec.gov/rules/
final/2007/33-8879.pdf.
Sydney Online 2014, ‘Splendour and power of the Sydney Harbour Bridge’, accessed September
2016, http://www.sydney.com.au/bridge.htm.
West, B. P. 2003, Professionalism and Accounting Rules, Routledge, New York.
Optional reading
ICAS (Institute of Chartered Accountants of Scotland) 2016, A Professional Judgement Framework
for Financial Reporting Decision Making, 2nd edn, ICAS, Edinburgh.
IFRS Foundation 2017, Conceptual Framework for Financial Reporting: Summary of Tentative
Decisions, June, accessed November 2017, http://www.ifrs.org/-/media/project/conceptual-
framework/current-stage/summary-of-tentative-decisions-june-2017.pdf.
FINANCIAL REPORTING
Module 2
PRESENTATION OF FINANCIAL STATEMENTS
90 | PRESENTATION OF FINANCIAL STATEMENTS
Contents
Preview 93
Introduction
Objectives
Assumed knowledge
Case study data: Webprod Ltd
Teaching materials
Part A: Presentation of financial statements

97
Introduction 97
Complete set of financial statements 98
Components of complete set of financial statements
MODULE 2
Segment reporting
Fair presentation and compliance with International Financial Reporting Standards
Other general features
Accounting policies 104
Selection of accounting policies
Disclosure of accounting policies
Changes in accounting policies
Revision of accounting estimates and correction of errors 110
Changes in accounting estimates
Material errors in a prior period
Events after the reporting period 113
Summary 119
Part B: Statement of profit or loss and other

comprehensive income 121
Introduction 121
Presentation of comprehensive income 121
The concept of other comprehensive income and total
comprehensive income 122
IAS 1—disclosures and classification 124
1. Single statement (statement of profit or loss and other comprehensive income)
2. Two statements (statement of profit or loss and a statement of profit or loss
and other comprehensive income)
Tips on how to analyse the statement of profit or loss and
other comprehensive income 130
Summary 131
Part C: Statement of changes in equity 132

Introduction 132
IAS 1 Presentation of Financial Statements: Disclosures of changes
in equity 132
Summary 133
Part D: Statement of financial position 134

Introduction 134
Format of the statement of financial position 134
Presentation of assets and liabilities 135
Current assets and current liabilities
IAS 1 Presentation of Financial Statements: Disclosures in the notes
to the statement of financial position 137
Tips on how to analyse a statement of financial position 138
Summary 139
CONTENTS | 91
Part E: IAS 7 Statement of Cash Flows 140

Introduction 140
Assumed knowledge
Information to be disclosed 141
Reporting cash flows on a net basis
Other information to be disclosed in the statement of cash flow
Classification of cash flows
Common methods adopted on how to prepare a statement
of cash flows 144
Formula method
How does a statement of cash flows assist users of the
financial statements? 146
MODULE 2
Consolidated financial statements 146
Tips on how to analyse the statement of cash flows 147
Summary 148
Review 149
Case study data: Webprod Ltd 151
Assumed knowledge review 159

Assumed knowledge review questions 159
Assumed knowledge review answers 161
References 193
MODULE 2
Study guide | 93
Module 2:
Presentation of
MODULE 2
Study guide
Preview
Introduction
Module 1 discussed the international financial reporting environment, including the stakeholders
of financial reports and the institutional arrangements for regulating financial reporting.
As outlined in that module, accountants often have to make decisions about how to report
on complex arrangements and transactions, such as the classification and measurement of
financial instruments, revenue recognition and accounting for business combinations. In making
these decisions, accountants use the International Financial Reporting Standards (IFRSs) and
the Conceptual Framework for guidance. Module 1 contained a detailed discussion of the
Conceptual Framework, as it not only underpins the development of accounting standards but
is also used to make accounting policy decisions when no guidance is available from an IFRS.
Module 2 commences the discussion of accounting standards used in the preparation and
presentation of general purpose financial statements.
As discussed in Module 1, one of the principal qualitative characteristics that makes information
useful to users is comparability. To assess trends in an entity’s financial performance and position,
users must be able to compare the financial statements of the entity over time. Likewise,
comparability is important when evaluating the financial performance and position of an entity
relative to other entities (Conceptual Framework, para. QC20). For this reason, Module 2
commences by considering the requirements specified in International Accounting Standard 1
Presentation of Financial Statements (IAS 1) for the preparation and presentation of general
purpose financial statements.
Paragraph 10 of IAS 1 specifies the components of a set of financial statements, which include
the following:
• a statement of financial position
• a statement of profit or loss (P&L) and other comprehensive income (OCI)
• a statement of changes in equity
• a statement of cash flows
• explanatory notes (including accounting policies)
• comparative information with respect to the preceding period
• a statement of the financial position at the beginning of the preceding period when
an accounting policy is applied retrospectively or items in the financial statements are
retrospectively restated or reclassified.
MODULE 2
IAS 1 specifies the overall considerations that should be used when preparing financial
statements. These considerations include:
• fair presentation
• going concern
• accrual basis of accounting
• materiality and aggregation
• offsetting
• frequency of reporting
• comparative information
• consistency of presentation.
Each of these considerations is discussed later in the module.
IAS 1 requires a complete set of general purpose financial statements to disclose the accounting
policies used in preparing and presenting the financial statements. According to para. 10 of
IAS 8, preparers of financial statements must choose accounting policies that are both relevant
to decision-making and reliable. Accounting policy choices have a major influence on the
results and financial position reported by an entity, and it is important for comparability reasons
that users are able to determine differences in financial performance or position, due to the
adoption of alternative accounting policies. Therefore, as part of the overall considerations in
preparing and presenting general purpose financial statements, this module discusses IAS 8
Accounting Policies, Changes in Accounting Estimates and Errors (IAS 8). IAS 8 specifies how to
determine accounting policies and the disclosures required for accounting policies and changes
in accounting policies. In addition, IAS 8 deals with the accounting treatment of accounting
estimates revisions and error corrections, which can significantly affect the presentation of
financial statements.
Part A of this module discusses events after the reporting period and briefly outlines the
requirements of IAS 34 Interim Financial Reporting (IAS 34) and IFRS 8 Operating Segments
(IFRS 8).
An important principle when preparing financial statements is that they must be prepared
on the basis of conditions in existence at the end of the reporting period. In the time between
the end of the reporting period and completion of the financial statements, events can occur
that either:
• clarify or confirm conditions that existed at the end of the reporting period, or
• give rise to new conditions.
Study guide | 95
IAS 10 Events after the Reporting Period (IAS 10) deals with how to treat these events when
preparing the financial statements. In some cases, an event after the reporting period will mean
adjustments to the financial statements are required. In other circumstances, an event after
the reporting period may lead to separate disclosure in the notes to the financial statements.
Such note disclosures are necessary when the information could influence the decisions of
financial statement users.
Part B focuses on the reporting requirements of the individual financial statements that must
be included in the set of financial statements, beginning with the P&L and OCI.
In relation to the P&L and OCI, this module considers the requirements of IAS 1, which
specifies both:
MODULE 2
• how an entity determines comprehensive income
• the information to be presented in the P&L and OCI or in the notes to the financial statements.
Part C discusses the statement of changes in equity, which discloses changes in each component
of equity and reconciles the opening and closing balances of the components. Changes in equity
will include comprehensive income and transactions with owners in their capacity as owners.
Part D deals with the statement of financial position. IAS 1 prescribes:

• how assets and liabilities must be presented
• how assets, liabilities and equity items must be classified
• which disclosures must be made on the face of the statement of financial position and
in the notes to the financial statements.
Finally, Part E looks at the statement of cash flows, which helps users assess the entity’s ability to
generate cash flows and the timing and certainty of their generation (IAS 7, ‘Objective’). IAS 7
Statement of Cash Flows (IAS 7) deals with the preparation and presentation of a statement of
cash flows and covers issues such as the definition of cash and cash equivalents, classification
of cash inflows and outflows, reconciliations required and disclosure of information about
cash flows.
Objectives
• explain and apply the requirements of IAS 1 with respect to a complete set of financial
statements and in relation to the considerations for the presentation of financial statements;
• outline and explain the requirements of IAS 8 for the selection of accounting policies;
• explain and apply the accounting treatment and disclosure requirements of IAS 8 in relation
to changes in accounting policies, and changes in accounting estimates and errors;
• explain and discuss the required treatment for both adjusting and non-adjusting events
occurring after the reporting period in accordance with IAS 10;
• explain and apply the requirements of IAS 7 with respect to preparing a statement of cash
flows; and
• discuss how a statement of cash flows can assist users of the financial statements to assess
the ability of an entity to generate cash and cash equivalents.
Assumed knowledge
It is assumed that before commencing your study in this module, you are able to:
• explain the four primary financial statements, including their purpose and interrelationship
• identify the content contained within each financial statement, including its structure
and format
• identify the assumptions and doctrines underpinning the preparation and presentation
of financial statements
• identify how a listed entity is required to identify and report its operating segments in the
• explain the importance of accounting policies and the criteria as to how they are selected
in the preparation and presentation of financial statements
• identify the accounting treatment between a change in accounting policy, change in
MODULE 2
accounting estimate and the discovery of a material error in a prior period

• identity the effects of events and transactions that occur after the end of the reporting date
and prior to the date that the financial statements are signed off and authorised for issue
• explain the two types of events that occur after the end of the reporting period, namely
adjustable events and non-adjustable events and their impact on the financial statements
• understand the purpose of a statement of cash flows and the reasons why it is considered
useful for decisions by users of financial statements
• understand the format and presentation of a statement of cash flows, including what
constitutes ‘cash and cash equivalents’ as well as the three types of cash flows that form
part of a statement of cash flows.

Module 2 includes case study data in a separate section at the end of this module. This case
study data will be used for a number of questions throughout the module.
Teaching materials
International Accounting Standards Board (IASB):
• IAS 7 Statement of Cash Flows
• IAS 10 Events after the Reporting Period
• IAS 34 Interim Financial Reporting
• IFRS 8 Operating Segments
• A set of example financial statements for a fictional business, Techworks Ltd, is provided as an
appendix to the Study guide, and is also available on My Online Learning. The Techworks Ltd
financial statements will be used for activities and questions throughout the module.
• Learning Task content supports this module. You can access this task on My Online Learning.
The Financial Statements Learning Task includes a discussion of preparing a financial P&L
and OCI and provides the opportunity for further practice.
Note that while the Financial Statements Learning Task provides valuable reinforcement
of the module discussion, it is not mandatory to use this resource.
Study guide | 97
Part A: Presentation of financial

statements
Introduction
IAS 1 specifies the requirements for:
1. the components of a complete set of financial statements
2. the overall considerations in preparing financial statements
3. the structure and content of particular financial statements.
MODULE 2
Part A provides an overview of the requirements contained in IAS 1 for an entity to prepare
and present a ‘complete set of financial statements’.
Part A goes on to discuss a range of accounting standards related to IAS 1 and the preparation
and presentation of financial statements, IAS 8. The requirements for listed entities to disclose
their operations according to their segments is also briefly discussed in IFRS 8.
Part A also discusses events arising after the reporting period. IAS 10 deals with how to treat
events and transactions that occur from the end of the reporting period to the date that the
financial report is signed off by the directors.
Relevant paragraphs
To help you achieve the objectives outlined in the module preview, you may wish to read the
relevant paragraphs in the following accounting standards. Where specified, you will need to be
able to apply these paragraphs:
IAS 1 Presentation of Financial Statements:
Subject Paragraphs
Complete set of financial statements 10–14
Fair presentation and compliance with IFRSs 15–24
Going concern 25–26
Accrual basis of accounting 27–28
Materiality and aggregation 29–31
Offsetting 32–35
Frequency of reporting 36–37
Comparative information 38–38D, 40A–44
Consistency of presentation 45–46
IAS 8 Accounting Policies, Changes in Accounting Estimates and Errors:
Subject Paragraphs
Selection and application of accounting policies 7–12
Consistency of accounting policies 13
Changes in accounting policies 14–27
Disclosure of changes in accounting policies 28–31
Changes in accounting estimates 32–40
Errors 41–42
IAS 10 Events after the Reporting Period:
Subject Paragraphs
Definitions 3
Adjusting events after the reporting period 8 –9
Non-adjusting events after the reporting period 10–11
Dividends 12–13
Disclosures 17–22
Complete set of financial statements

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Components of complete set of financial statements

IAS 1 applies to general purpose financial statements prepared in accordance with IFRSs.
IAS 1 states that the purpose 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
(para. 9).
If you wish to explore this topic further you may now read paragraph OB2 of the Conceptual
Framework to remind yourself of the objective of general purpose financial reporting as discussed
in Module 1. Think about the differences between this objective and the objective outlined in para. 9
of IAS 1.
A complete set of financial statements as stated in para. 10 of IAS 1 contains the following:
• a statement of financial position
• a P&L and OCI
• a statement of changes in equity
• a statement of cash flows
• notes, which include accounting policies and explanatory notes
• comparative information regarding the preceding period
• a statement of the financial position as at the beginning of the earliest comparative
period when any of the following occurs:
–– an accounting policy is applied retrospectively
–– items in the financial statements are retrospectively restated, or
–– items in the financial statements are reclassified.
The complete set of financial statements required under IAS 1 is illustrated in Figure 2.1.
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Figure 2.1: A complete set of financial statements
A complete set of financial statements

under IAS 1 comprises
Statement of Statement of Statement of Statement of

profit or loss and other + changes in equity + financial position + cash flows
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Notes to the accounts
Entities are permitted to use other appropriate titles for the financial statements (e.g. income
statement and balance sheet). This is confirmed in para. 10 of IAS 1. The titles for each financial
statement listed in para. 10 are not mandatory, and entities may use different titles.
These financial statements are the ones used in the preparation of general purpose financial
statements (i.e. when the entity is considered to be a reporting entity). However, in the case of
an Australian non-reporting entity, only special purpose financial statements are prepared.
Special purpose financial statements can be prepared in accordance with the special needs of
the users in mind. Non-reporting entities that prepare special purpose financial statements are
only required to apply those accounting standards that are considered necessary to present
a ‘true and fair’ view. This has been interpreted that a non-reporting entity must apply the
recognition and measurement requirements of those accounting standards (e.g. depreciation,
tax-effect accounting, leases, inventories, employee benefits) but not necessarily the disclosure
requirements of each standard.
According to para. 9 of Australian Accounting Standards Board (AASB) 1054 Australian Additional
Disclosures, which was issued in May 2011, an entity is required to disclose in its accounting
policy note whether the financial statements are general purpose or special purpose financial
statements. As such, users should be mindful of whether the financial statements being read are
general purpose or special purpose financial statements.
Entities are expected to give ‘equal prominence to all of the financial statements in a complete
set of financial statements’ (para. 11). As will be discussed in Part B, the components of a P&L can
be presented either in a single P&L and OCI or in a separate P&L (para. 10A).
If you wish to explore this topic further you may now read paras 10–11 of IAS 1.
The requirements of IAS 1 for a complete set of financial statements are also relevant for interim
financial reports (IAS 34, para. 5). IAS 34 does not specify which entities have to prepare interim
financial reports, as this is usually specified by governments, stock exchange requirements and
other regulators (IAS 34, para. 1). The aim of an interim financial report is to provide financial
statement users with timely and reliable information, concepts that were discussed in Module 1
(IAS 34, ‘Objectives’). Paragraph 19 of IAS 34 requires entities that prepare an interim financial
report to disclose their compliance with the requirements of the standard, which includes the
requirement of IAS 1 to comply with IFRSs.
If you wish to explore this topic further you may now read the ‘Objectives’ paragraph and paras 1,
5 and 19 of IAS 34.
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In addition to the complete set of financial statements, entities may provide additional
information required by the Corporations Act 2001 (Cwlth) or disclosed voluntarily.
Some examples would include:
• a review by management of the entity’s financial performance, including changes in
the environment in which the entity operates
• details about the entity’s sources of funding
• details of the entity’s resources not recognised in the financial statements.
Furthermore, many entities also present environmental reports and value added statements
that are outside the financial statements. Reports and statements presented outside financial
statements are outside the scope of IFRSs.
If you wish to explore this topic further you may now read paras 13 and 14 of IAS 1 to expand on
this discussion.
Segment reporting
The additional information discussed in paras 13 and 14 is to help users evaluate the activities
and performance of an entity. IFRSs often contain disclosure requirements to assist financial
statement users with their evaluations and decisions. An example of such additional disclosures
is contained in IFRS 8.
IFRS 8 requires that, where an entity has publicly traded debt or equity instruments, the notes to
its financial statements must provide both financial (profit or loss, revenues, expenses, assets and
liabilities) and general information for each of its reportable operating segments. Information
includes details of the entity’s:
• products and services
• geographical areas of operations
• major customers.
The aim of providing such information is to help financial statement users ‘to evaluate the nature
and financial effects of the business activities in which it engages and the economic environments
in which it operates’ (IFRS 8, paras 1 and 20).
An operating segment is identified as a component of the entity that:

• undertakes business activities from which it may generate revenues and incur expenses
• has its operating result regularly reviewed by the chief operating decision maker within the
entity, such as the general manager, managing director or chief executive officer (CEO)
• has discrete financial information available (IFRS 8, para. 5).
Therefore, the focus is to identify operating segments on the basis of internal decision-making.
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If you wish to explore this topic further you may now read Note 20 of the Techworks Ltd 2016
financial statements (in the appendix of the Study guide, and also available on My Online Learning),
which provides information for the company’s three reportable segments, namely:
• retail, IT consumables and electronics
• SaaS ‘on demand’
• IT consulting and implementation.
As stated in Note 20, the above reportable segments have been identified by the company's chief
operating decision-maker as reportable operating segments. According to IFRS 8, information about
reportable segments:
• reflects the structure used by management to assess group performance
• is an allocation of items contained in the financial statements of the company to help users
evaluate the financial effects of the company’s business activities and the economic environments
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in which it is working.
Fair presentation and compliance with International Financial

Reporting Standards
IAS 1 requires financial statements to present fairly the entity’s financial performance, financial
position and cash flows. Fair presentation requires faithful representation of transactions,
other events and conditions in accordance with the Conceptual Framework’s definition and
recognition criteria for the elements of financial statements (assets, liabilities, income and
expenses). In addition, para. 15 of IAS 1 contends that applying IFRSs with additional disclosures
when necessary will result in general purpose financial statements being presented fairly.
Paragraph 16 of IAS 1 requires entities with financial statements prepared in accordance with
the IFRSs to make an explicit and unreserved statement of such compliance in the notes to
the accounts.
In the extremely rare circumstance in which compliance with an IFRS would not result in a fair
presentation, departure from that IFRS is permitted, provided:
• the regulatory framework permits such departure
• the entity discloses detailed information about the departure (IAS 1, para. 19).
This detailed information includes:

• a statement that management believes the departure provides financial statements that
present fairly
• details of the departure
• reasons why the IFRS treatment is considered misleading
• the financial impact of the departure on the entity’s profit, financial position and cash flows
(IAS 1, para. 20).
IAS 1 makes it clear that adopting an accounting policy that is not permitted by an IFRS and
disclosing the details in the notes to the financial statements does not overcome non-compliance
with an IFRS (para. 18). Departure from an IFRS is only permitted when compliance with the
IFRS will result in an unfair presentation.
If you wish to explore this topic further you may now read paras 15–24 of IAS 1, which confirm and
expand on this discussion.
Other general features

In addition to requiring financial statements to be presented fairly, IAS 1 specifies a number
of other general features that must be complied with when preparing and presenting general
purpose financial statements. These include:
• going concern
• accrual basis
• materiality and aggregation
• offsetting
• frequency of reporting
• comparative information
• consistency.
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Going concern
During the preparation of financial statements, an assessment must be made as to whether the
entity concerned has the ability to continue as a going concern. IAS 1 requires in part that:
An entity shall prepare financial statements on a going concern basis unless management either
intends to liquidate the entity or to cease trading, or has no realistic alternative but to do so
(IAS 1, para. 25).
There is no specific requirement in IAS 1 for the entity to disclose that it is considered a going
concern. This is an implicit assumption when preparing financial statements. However, where the
entity is not considered a going concern, this must be disclosed together with the reasons why
the entity is not considered a going concern and the basis on which the financial statements are
prepared. If there is significant uncertainty as to the continuity of an entity’s operations but the
financial statements are still prepared on a going concern basis, then details of the uncertainty
should be disclosed (para. 25).
Where an entity is no longer considered a going concern (typically where the entity’s liabilities
exceed its assets, resulting in a situation of negative shareholders’ equity), then the financial
statements should be prepared on a realisable (or liquidation) basis. This means that all assets
and liabilities should be shown at their realisable values, as all assets are expected to be sold in
the next 12 months.
If you wish to explore this topic further you may now read paras 25 and 26 of IAS 1.
Accrual basis
Paragraph 27 of IAS 1 requires that, with the exception of cash flow information, financial
statements be prepared under accrual accounting principles. This provides users with information
about the financial performance and financial position that would not be available if the cash
basis were used.
Materiality and aggregation

Financial statements are a summary of all the financial transactions of an entity for the reporting
period. It would be meaningless to present users with details of every transaction, so the
financial statements group together certain transactions. IAS 1 uses the concept of materiality
as the guideline for assisting preparers in deciding which items can be added together and
which must be separately reported in financial statements.
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IAS 1 requires that:

an entity shall present separately each material class of similar items. An entity shall present
separately items of a dissimilar nature or function unless they are immaterial (para. 29).
Information is considered material if its omissions or misstatements of items are material—that is,

if they could individually or collectively influence the economic decisions that users make on
the basis of the financial statements. 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 (IAS 8, para. 5).
Assessing whether an item is considered material requires consideration of the needs of users.
The AASB (2004) Framework for the Preparation and Presentation of Financial Statements
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states that:
Users are assumed to have a reasonable knowledge of business and economic activities and
accounting and a willingness to study the information with reasonable diligence (para. 25).
Therefore, the assessment needs to take into account how users with such attributes could
reasonably be expected to be influenced in making economic decisions.
Finally, it is important to note that the disclosure requirements of the IFRSs do not apply to
immaterial items (IAS 1, para. 31).
Offsetting
Offsetting, or combining the balances, of assets and liabilities or income and expenses may
result in the loss of relevant information for financial statement users. Therefore, IAS 1 prohibits
offsetting, except where required or permitted by a particular standard. For example, IAS 12
Income Taxes (IAS 12) permits the offsetting of current tax assets and current tax liabilities in the
statement of financial position, provided that the entity:
• has a legally enforceable right to set off the recognised amounts
• intends either to settle on a net basis, or to realise the asset and settle the liability
simultaneously (IAS 12, para. 71).
Reporting assets net of valuation allowances (e.g. receivables net of the allowance for doubtful
debts) is not offsetting and is permitted (IAS 1, para. 33).
Frequency of reporting
An entity usually presents its financial statements (including comparative information) at least
annually. However, some entities are required to prepare half-yearly financial statements.
For example, according to s. 302 of the Corporations Act, a disclosing entity is required to
prepare and lodge half-yearly financial statements with the Australian Securities and Investments
Commission (ASIC) and the Australian Securities Exchange (ASX).
A disclosing entity is defined in s. 111AC of the Corporations Act as an entity that issues
‘enhanced disclosure’ (ED) securities. The content of a half-yearly report contains condensed
financial statements and substantially reduced disclosure requirements. Reference should
be made to IAS 34.
Comparative information
An entity should present comparative information regarding the preceding period for all amounts
reported in the current period’s financial statements, except when the IFRSs permit or require
otherwise (IAS 1, para. 38).
As a minimum, this will involve presenting two of each of the financial statements (IAS 1, para. 38A).
Paragraph 40A of IAS 1 requires the presentation of a third statement of financial position as at the
beginning of the preceding period if:
• it applies an accounting policy retrospectively, makes a retrospective restatement of items
in its financial statements or reclassifies items in its financial statements
• the retrospective application, retrospective restatement or the reclassification has a material
effect on the information in the statement of financial position at the beginning.
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Where items in the financial statements are reclassified, the comparative amounts should also
be reclassified, unless it is impracticable to do so (IAS 1, para. 41). Where it is impracticable,
the entity should disclose the reasons why and the ‘nature of the adjustments that would have
been made if the amounts had been reclassified’ (IAS 1, para. 42).
If you wish to explore this topic further you may now read paras 38, 38A, 40A and 41–44 of IAS 1.
Consistency
Financial statements should be prepared on a consistent basis from one period to the
next, as described in para. QC22 of the IASB Conceptual Framework. The presentation and
classification of items contained in the financial statements should only be changed when:
• ‘a significant change’ has occurred in an entity’s operations, or after reviewing the entity’s
financial statements, management is of the opinion that a change in accounting policy is
necessary to show a more appropriate presentation or classification, or
• a change is required by an IFRS (IAS 1, para. 45).
Accounting policies
A complete set of financial statements identified in para. 10 of IAS 1 includes notes that comprise
‘a summary of significant accounting policies and other explanatory information’. For users
to be able to compare the financial statements of different entities across different reporting
periods, it is important that there is adequate disclosure of accounting policies. This will provide
the necessary information for users to make allowances for differences in the financial results of
different entities that are due to different accounting policies.
Refer to Note 1 ‘Accounting policies’ in the notes to financial statements of the 2016 financial
statement of Techworks Ltd.
Note how the accounting policies enable the financial statement user to determine the basis
of preparation of the financial report and the accounting policies adopted in relation to various
items, such as the basis of accounting (Note 1(b)), the basis of consolidation (Note 1(e)), plant and
equipment (Note 1(k)) and revenue recognition (Note 1(p)), to give a few examples.
If you wish to explore this topic further you may now read paras QC20–QC25 of the Conceptual
Framework, which discuss the importance of the comparability characteristic.
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Selection of accounting policies

Accounting policies are defined as the specific rules, principles, bases, conventions and practices
applied by an entity in preparing and presenting financial statements. Examples of accounting
policies include whether to capitalise or expense borrowing costs and whether to value
non‑current assets at cost or at fair value.
According to para. 7 of IAS 8, when management is selecting appropriate accounting policies,

they should first determine the applicability of the IFRSs. In addition, the accounting policy
should take into account any implementation guidance associated with a relevant IFRS where
it is mandatory (IAS 8, para. 9). It is important to note that para. 5 of IAS 8 defines IFRS to
encompass standards and interpretations adopted by the IASB. They include:
• IFRSs
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• IASs
• interpretations of accounting standards developed by the IFRS Interpretations Committee
(referred to as IFRIC)
• Standards Interpretations Committee (SIC) Interpretations previously issued by the IASB.
As such, an accounting policy for a particular transaction, event or condition must comply with
any relevant accounting standards (and consider any relevant implementation guidance issued by
the IASB) and IASB Interpretations.
If you wish to explore this topic further you may now read the definition of ‘International Financial
Reporting Standards’ in paras 5 and 7–9 of IAS 8.
Where there are no specific IFRS requirements, management should use professional judgment
and develop accounting policies in a manner that ensures financial statements provide
information that is:
a) relevant; and
b) reliable, in that they:
i. represent faithfully the financial position, financial performance and cash flows of the entity,
ii. reflect the economic substance of events and transactions and not merely the legal form,
iii. are neutral,
iv. are prudent, and
v. are complete in all material respects (IAS 8, para. 10).
Please note that, as discussed in Module 1, ‘relevant’ and ‘reliable’ would now be referred to in
the context of the fundamental qualitative characteristics of relevance and faithful representation
as outlined in the Conceptual Framework (paras QC4–QC16).
Paragraph 11 of IAS 8 provides additional guidance on the selection of appropriate accounting

policies. Where there is no relevant IFRS, management shall refer (in the following priority order)
to guidance in:
• the requirements in the IFRSs that deal with similar and related issues
• the Conceptual Framework’s definitions, recognition criteria and measurement concepts
for assets, liabilities, income and expenses.
In making this judgment, management may also refer to pronouncements of other standard-
setting bodies that use a similar Conceptual Framework, other accounting literature and industry
practice, but only to the extent that these are consistent with the preceding two sources of
guidance (IAS 8, para. 12).
Disclosure of accounting policies

Accounting policies adopted by an entity can significantly affect the way profits and financial
position are reported. This influences economic decisions and other evaluations, including
evaluations about the discharge of managerial accountability by users of those statements.
As such, it is desirable that users are provided with information about those policies and
changes therein.
Paragraph 112(a) of IAS 1 requires that the notes to the financial statements include
information in relation to accounting policies selected for significant transactions and events.
More specifically, para. 117 of IAS 1 requires that the notes to the financial statements
include information concerning:
• ‘the measurement basis (or bases) used in preparing the financial statements’
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• details of all other accounting policies necessary to understand the financial statements.
If you wish to explore this topic further you may now read the following paragraphs of IAS 1:
• 112–117, which outline the requirements for the structure of the notes to the financial statements
and the disclosure requirements for accounting policies
• 118–121, which expand on the requirements of para. 117
• 122–124, which discuss the disclosure requirements for judgments that management has made
in determining accounting policies
• 125–127, which discuss the disclosure requirements relating to information concerning the
key sources of estimation uncertainty at the end of the reporting period, which may require
adjustments to the amount of assets or liabilities in the next financial year.
➤➤Question 2.1
(a) Refer to Note 1 of the 2016 financial statements of Techworks Ltd. Explain how the summary
complies with the requirements of paras 112 and 117 of IAS 1.
(b) Refer to the ‘Case study data’ section at the end of this module. Prepare the initial section
of the accounting policy notes relating to the significant accounting policies of Webprod Ltd.
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Changes in accounting policies

For users to be able to compare the performance of an entity over a period, it is important that
the financial statements are prepared using the same accounting policies. Accounting policies
are defined as the ‘specific principles, conventions, rules and practices applied by an entity in
preparing and presenting financial statements’ (IAS 8, para. 5).
However, many of the accounting standards provide a choice of accounting policies. Examples of
accounting policies include the choice whether to adopt the cost or fair value models in relation
to tangible assets (IAS 16) or intangible assets (IAS 38) and whether to capitalise or expense
borrowing costs (IAS 23).
Therefore, the selection of accounting policies becomes a matter of professional judgment for
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the entity, its governing body and, ultimately, the accountant (or auditor). According to para. 10
of IAS 8, the fundamental guiding principle when selecting accounting policies is to reflect
the economic substance of the transaction rather than its legal form. IAS 8 considers that this
approach ultimately results in the selection of accounting policies that are both relevant to
decision-making and reliable.
According to para. 13, accounting policies should be applied consistently over time and from
period to period. However, that does not mean that an entity can never change its accounting
policies. An entity is permitted to change its accounting policy. This issue is specifically covered
in paras 14–31 of IAS 8.
An entity should only change accounting policies when required by an IFRS or the change
will result in the provision of more relevant and reliable information about the entity’s financial
position, financial performance or cash flows (IAS 8, para. 14).
IAS 8 specifically excludes the following as changes in accounting policy:

• application of an accounting policy for events or conditions that differ in substance from
previous events or conditions
• application of a new accounting policy for events or conditions that in previous reporting
periods did not exist or were immaterial (para. 16).
Where an entity changes an accounting policy because of a new IFRS, it must apply the
transitional provisions in the IFRS (IAS 8, para. 19(a)). When there are no transitional provisions
in the IFRS, or the entity is making a voluntary change in accounting policy, the accounting policy
change must be made retrospectively (para. 19(b)). That is, two adjustments must be made to
financial statements. First, the opening balance of each component of equity affected by the
change must be adjusted for the earliest prior period presented in the financial statements
(para. 22). Second, the other comparative amounts disclosed for each prior period presented
must be restated as if the new policy had always been applied by the entity (para. 22).
Example 2.1: Change in accounting policy

Capricorn Ltd is an Australian diamond wholesaler. It has a financial year-end of 30 June. Due to extreme
fluctuations in the price of diamonds, which it imports from all over the world, the cost of inventory
has become extremely volatile, and this volatility is expected to continue indefinitely in the future.
Due to these circumstances, on 1 July 20X5, in accordance with IAS 2 Inventories, Capricorn Ltd has
decided to voluntarily change its inventory valuation method from weighted average cost to first-in,
first-out (FIFO). The company's directors believe that this change in accounting policy more accurately
reflects the economic substance and results in more relevant and reliable information.
The impact of this change in accounting policy resulted in an increase in the value of inventory on
hand by $78 000 at 30 June 20X5 and an increase of $52 000 at 30 June 20X4.
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Assume that the company is unable to determine or calculate the impact of this change of accounting
policy from any date prior to 30 June 20X4.
As this represents a voluntary change in accounting policy, it must be accounted for retrospectively
(IAS 8, para. 19(b)). The first period for which retrospective application is practicable is 30 June 20X5.
This will involve restating the opening inventory balance upwards by $52 000 with a corresponding
change to closing inventory in the income statement. This will wash through as an adjustment to
opening retained profits. For the year ended 30 June 20X5, closing inventory will increase by $78 000
with a corresponding adjustment in the income statement to closing inventory.
IAS 8 requires that a ‘catch-up’ adjustment be made starting from the date of the initial
transaction. If this is in a period not covered by the financial statements, then the adjustment
is made to the opening balance of retained profits (IAS 8, paras 19(b) and 22).
However, para. 23 recognises that in some cases it may be ‘impracticable’ to adjust comparative
information for one or more prior periods (e.g. the data are no longer available or not able to
be collected).
In this case, according to paras 44 and 45 of IAS 8, the new accounting policy must be applied
from the earliest date practicable (which may be the current reporting period).
For example, if it is not possible to determine exactly when the initial transaction was recorded
in the financial statements (and therefore, impracticable to determine the financial impact of the
change in accounting policy from this date), then the adjustment is made in the comparative
information in the current financial statements. In other words, the respective figures in the
comparative column are directly adjusted with any catch-up revenue or expense amendments
adjusted through opening retained profits.
If you wish to explore this topic further you may now read the following:
• paras 23–27 of IAS 8
• the definition of ‘impracticable’ in para. 5 of IAS 8
• the guidance on impracticability in relation to the retrospective application of a new accounting
policy in paras 50–53 of IAS 8
• Example 3 in the ‘Guidance on implementing IAS 8 Accounting Policies, Changes in Accounting
Estimates and Errors’ (in Part B of the Red Book), which deals with the prospective application
of a change in accounting policy when retrospective application is impracticable.
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Where an entity changes an accounting policy, it must not only apply the policy retrospectively
(where it is practical to do so and which involves making every reasonable effort to do so), but it
must also make several disclosures.
If the accounting policy change arises from the initial application of a standard or interpretation,
the entity must disclose information including items such as:
• ‘the title of the IFRS’ and description of transitional provisions if applicable
• the nature of the change
• the amount of adjustment for each financial statement item affected
• the adjustments relating to prior periods (IAS 8, para. 28).
If an entity makes a voluntary change in accounting policy that has an effect on the current,
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prior or potentially a future reporting period, the entity must disclose information items such as:
• the nature of the change
• the reasons why the change provides ‘reliable and more relevant information’
• the amount of adjustment for each financial statement item affected (current and prior period)
• the amount of the adjustments relating to periods before those presented
• advice (where applicable) that retrospective application is impracticable for a particular prior
period or for periods before those presented, the circumstance that led to the existence
of that condition and a description of how and from when the change has been applied
(IAS 8, para. 29).
Finally, it should be noted that in some situations an entity may prepare financial statements that
do not comply with a new standard or interpretation because it is not effective until after the end
of the reporting period. In such situations, the entity should disclose this situation and provide
information about the potential impact of applying the new standard or interpretation (IAS 8,
para. 30).
If you wish to explore this topic further you may now read paras 28–31 of IAS 8. In addition,
re‑reading paras 19 and 22 of IAS 8 may be helpful.
➤➤Question 2.2
(a) Refer to Note 1(b) ‘Accounting policies’ in the notes to financial statements of the 2016
financial statement of Techworks Ltd. This note refers to certain new accounting standards
and interpretations that have been published by the IASB and AASB and that are mandatory
for 30 June 2016 reporting period.
Which accounting standards have been identified by the directors of Techworks Ltd as those
that have not been adopted at 30 June 2016 but that are likely to impact on the financial
statements in future reporting periods?
(b) Under Section 334(5) of the Corporations Act, Australian companies have the option of early
adopting accounting standards. These are accounting standards that have been issued by the
IASB or AASB but do not apply until a future financial reporting period. Review Note 1(b)
‘Accounting policies’ in the notes to financial statements of the 2016 financial statement of
Techworks Ltd. Has Techworks Ltd early adopted any AASB accounting standards?
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(c) Refer to sections 5 and 6 of the ‘Case study data’. Prepare any disclosures necessary to be
included in the notes to the financial statements.
Revision of accounting estimates

and correction of errors
Changes in accounting estimates
Many items included in financial statements involve measurements that require estimations.
Estimates include:
• bad debts
• inventory obsolescence
• the fair value of financial assets and liabilities
• the useful lives of depreciable assets
• warranty obligations.
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In subsequent reporting periods, as new information is received or new developments occur,

accounting estimates may have to be revised. In relation to changes in estimates, IAS 8:
• requires income and expense adjustments as a result of the revision to be recognised
in either the current reporting period, or the current and future reporting periods,
depending on which periods the change of estimate affects (para. 36)
• specifies that, where relevant, adjustments to assets, liabilities and equity items should
be made in the reporting period of the change of estimate (para. 37)
• specifies disclosure of the nature and amount of the revision in the accounting estimate
where the change affects the current reporting period and, to the extent it is practicable,
disclosure of the effect on future reporting periods (para. 39).
Put simply, according to IAS 8, a change of accounting estimate can be made only prospectively—
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that is, change can affect only the current period and future periods. The change cannot be
made retrospectively.
Example 2.2: Change in an accounting estimate

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

IAS 8 also deals with the issue of material errors made in a prior period. There may be times when
a material error (i.e. a mistake) has been made in a previous financial period that is not covered
by the current financial statements (i.e. current year and previous year comparatives) but is only
discovered in the current reporting period.
An example of a material error is realising in the current period that land sold in a previous
financial year was not accounted for correctly in the previous year‘s accounts. Paragraph 5 of
IAS 8 also acknowledges that an error could include mathematical mistakes, mistakes in applying
accounting policies, oversights or misinterpretations of facts or fraud.
Financial statements are considered not to comply with the accounting standards if they
‘contain either material errors or immaterial errors made intentionally to achieve a particular
presentation of an entity’s financial position, financial performance or cash flows’ (IAS 8, para. 41).
When material errors are discovered in a reporting period subsequent to the reporting period
(or periods) in which the error occurred, IAS 8 requires retrospective correction of the error in the
first set of financial statements issued after the error’s discovery (IAS 8, para. 42). The error must
be corrected by either:
• restating comparative amounts in the financial statements if they relate to reporting periods
that were affected by the error, or
• if the error occurred before the earliest prior period presented in the financial statements,
by restating ‘the opening balances of assets, liabilities and equity for the earliest prior period
presented’ (para. 42).
In other words, according to para. 42 of IAS 8, material errors relating to prior reporting periods
are to be corrected retrospectively.
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If you wish to explore this topic further you may now read paras 41 and 42 of IAS 8 as well as
Example 1 of the ‘Guidance on implementing IAS 8 Accounting Policies, Changes in Accounting
Estimates and Errors’ (in Part B of the Red Book), which illustrates a retrospective restatement
of errors.
As with changes to accounting policies, IAS 8 requires that a ‘catch-up’ adjustment be made
starting from the date that the error was made. If this is in a period not covered by the financial
statements, then the adjustment is made to the opening balance of retained profits (paras 19(b)
and 22).
However, IAS 8 recognises that in some cases it may be ‘impracticable’ to adjust comparative
information for one prior period or more (e.g. the data are longer available or cannot be collected).
In this case, according to para. 47, when it is impracticable to determine the amount of an error
made in a prior period, then the adjustment is made at the beginning of the current financial
reporting period.
Furthermore, para. 40A-C of IAS 1 requires that a three-column balance sheet be presented
where a material error in a prior period affects the statement of financial position. The entity must
present the following balance sheets as at:
• the end of the current period
• the end of the previous period (which is the same as the beginning of the current period)
• the beginning of the earliest comparative period.
If you wish to explore this topic further you may now:

• re-read the definition of ‘impracticable’ in para. 5 of IAS 8
• re-read the guidance on impracticability in relation to retrospective application
and restatement of errors in paras 50–53 of IAS 8
• read paras 43–48 of IAS 8.
Finally, where a prior period error has been corrected in a reporting period, para. 49 of IAS 8
specifies disclosure of information including:
(a) the nature of the prior period error;
(b) for each prior period presented, to the extent practicable, the amount of the correction:
(i) for each financial statement line item affected; and
(ii) if IAS 33 (Earnings per share) applies to the entity, for basic and diluted earnings per share;
(c) the amount of the correction at the beginning of the earliest prior period presented; and
(d) if retrospective restatement is impracticable for a particular prior period, the circumstances that
led to the existence of that condition and a description of how and from when the error has
been corrected (IAS 8, para. 49).
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Example 2.3: Material errors in a prior period

Mixmaster Ltd owns 10 000 shares of a company that is listed on a public stock exchange. This investment
asset is measured at fair value through profit or loss (FVPL).
During the preparation of the financial statements for the year ended 30 June 20X6, the financial
controller noted that the shares had not been marked to market (revalued) in the prior year.
Shares are held at $100 000 ($10 per share), which was the price paid when they were originally
purchased in March 20X5. The share price at 30 June 20X5 was $9.50, and the share price at 30 June
20X6 was $10.50.
This is an example of an accounting error, and therefore, a retrospective adjustment is required when
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the error is discovered.
The error should be corrected by restating the comparative balances for 20X5. At 30 June 20X5,
the carrying amount of the shares was incorrectly shown as $100 000 but should have been recognised
at fair value of $95 000 (10 000 shares × $9.50). The following journal would need to be processed:
30 June 20X5
Dr Fair value movements in listed equities (FVPL) 5 000
Cr Investment in shares (asset) 5 000
A detailed note disclosure is also required to explain this adjustment.
At 30 June 20X6, the fair value of the shares increased to $10.50 per share. The fair value is now $105 000
(10 000 shares × $10.50). The journal entry required based on this adjustment is:
30 June 20X6
Dr Investment in shares (asset) 10 000
Cr Fair value movement in listed equities (P&L) 10 000
Events after the reporting period

It is important that financial statements reflect conditions that existed at the end of the reporting
period. The objective of IAS 10 is to prescribe if an entity should adjust its financial statements
for events occurring after the reporting period or provide additional note disclosures in the
An event after the reporting period, or a subsequent event, is defined in para. 3 of IAS 10 as an
event, favourable or unfavourable, that occurs between the end of the reporting period and the
date when the financial statements have been authorised for issue.
The date that statements have been authorised for issue is generally the date that the directors
sign the Directors’ Declaration (para. 17). If an event occurs after the signing off of the accounts,
then IAS 10 has no application (para. 18).
The timeline in Figure 2.2 illustrates the concept of events occurring after the balance date and
the application of IAS 10.
Figure 2.2: Application of IAS 10 Events after the Reporting Period

IAS 10 applies IAS 10 does not apply
Reporting date Date that the board/directors

of the entity ‘sign off’ the financial report
(e.g. 30 June) (e.g. 30 September)
Source: Based on IRFS Foundation 2017, IAS 10 Events after the Reporting Period,
in 2017 IFRS Standards, IFRS Foundation, London. © CPA Australia 2017.
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Types of events after the reporting period

Paragraph 3 of IAS 10 provides for two types of events that can occur after the reporting date:
(i) those that provide additional evidence of conditions that existed at the end of the reporting
period (called an ‘adjustable event‘)
(ii) those events that were not in existence at the end of the reporting period, but which arose
for the first time after the end of the reporting period (called a ‘non-adjustable event‘).
These are illustrated in Figure 2.3.
Figure 2.3: Types of events after the reporting period
Event after the reporting period
Adjustable events or Non-adjustable events
Events that require the financial Events that are required to be

statements to be adjusted disclosed as a note to the
(usually by way of a journal entry) financial statements
Adjustable events
An adjustable event is one that provides further evidence of conditions that existed at the
reporting date. According to para. 8 of IAS 10, an entity shall adjust the financial statements
to reflect these events.
In other words, an adjustable event provides additional information of an event that existed
at the end of the reporting period, but the amount was uncertain and had to be estimated.
The additional information after the reporting period usually confirms the correct amount that
must be provided in the financial statements.
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IAS 10 confirms that the financial statements need to be adjusted at the reporting date to reflect
this new information that has become available after the end of the reporting period but before
official sign-off. Examples of adjustable events include:
(a) where a court case that was in existence at reporting date, but had not been settled at reporting
date is subsequently decided after the reporting date where the outcome is now known
(b) where an asset value has been estimated at reporting date, and further information has
become available after the reporting date that alters or changes the value of the asset—
for example, the ascertainment of selling prices for inventory items, after the reporting
period, where those prices were uncertain at the reporting date, thereby affecting the
determination of the carrying amount of inventory items measured at net realisable values
(c) the determination after the reporting period of profit sharing or bonus payments, if the entity
had an obligation to make these payments before reporting date and these payments are
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subsequently made after reporting date
(d) the discovery of fraud or errors after the reporting period that reveals that the financial
statements were incorrect at the reporting date.
In the case of adjustable events, IAS 10 confirms that the financial report needs to be adjusted
to reflect this new information that has become available after the reporting date. This usually
means adjusting the figures in the financial statements by way of a journal entry. Paragraph 19 of
IAS 10 also requires disclosures about conditions that existed at balance date to be adjusted for
new information received after the reporting period (e.g. contingent liabilities).
Non-adjustable events
A non-adjustable event is one that arises after the reporting date for the first time. In other words,
this event did not relate to a condition that existed at the reporting date.
According to para. 10 of IAS 10, an entity shall not adjust the financial statements in respect of
these events. Instead, the event should be disclosed as a note in the financial statements.
Paragraphs 11 and 22 of IAS 10 provide the following examples of non-adjustable events:

• a decline in the market value of investments after the reporting date and the date when the
financial statements are authorised for issue. The decline in market value does not normally
relate to the condition of the investments at the reporting date but reflects circumstances
that have arisen subsequently
• a major business combination change after the reporting period (e.g. acquisition or disposal
of a subsidiary)
• announcing a plan to discontinue a business unit or operation after the reporting period
• major purchases or disposal of assets, or expropriation of major assets by government
• the destruction of a major production plant by a fire after the reporting period
• announcing or commencing the implementation of a major restructuring
• major share transactions (e.g. issuing new shares, bonus share issues) after the
reporting period
• changes in tax rates or tax laws enacted or announced after the reporting period date
that have a significant effect on current and deferred tax assets and liabilities
• abnormally large changes after the reporting period in asset prices or foreign exchange rates
• entering into significant commitments or contingent liabilities
• commencing major litigation arising solely out of events that occurred after the reporting period.
In the case of material non-adjustable events, IAS 10 confirms that the following information
is to be disclosed in the notes to the financial report:
• the nature and description of the event
• an estimate of the financial effect (or a statement that such an estimate cannot be made).
Figure 2.4 provides assistance in selecting between the two types of events after the reporting
period, namely adjustable and non-adjustable.
Figure 2.4: Selection of event type of IAS 10 Events after the Reporting Period
Has the new information become

available after the reporting date?
Yes No
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Did the condition exist at

No adjustment required
the reporting date?
Yes No
Was the amount reported at the

reporting date uncertain,
or did it need to be estimated?
Yes
No
Did new information become Non-adjustable event

available before sign-off?
Make the disclosure in the notes.

Yes
No
Does this information confirm what the
correct amount recognised at the
reporting date should be?
Yes
Adjustable event
Adjust the financial statements.
Source: Based on IRFS Foundation 2017, IAS 10 Events after the Reporting Period,
If you wish to explore this topic further you may now read paras 2–7 of IAS 10. Please now attempt
Question 2.3 to apply your knowledge of this topic.
➤➤Question 2.3
The following extract is from Note 36 of the 2014 annual report of BHP Billiton (statement of
financial position date is 30 June 2014):
On 2 September 2014, legislation to repeal the MRRT in Australia received the support
of both Houses of Parliament. The repeal will take effect at a later date to be fixed by
proclamation and therefore the MRRT will continue to apply until that date. At 30 June
2014, the Group carried an MRRT deferred tax asset (net of income tax consequences)
of US$698 million. Subject to determination of the effective date, an income tax charge
approximating this amount is expected to be recognised in the 2015 financial year
(BHP Billiton 2014, p. 292).
Study guide | 117
Comment on whether the preceding event would be regarded as an ‘adjusting event after the
reporting period’ or a ‘non-adjusting event after the reporting period’.
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If you wish to explore this topic further you may now read paras 8–11, 19 and 21 of IAS 10 to confirm
the content of Figure 2.4. Please now attempt Question 2.4 to apply your knowledge of this topic.
➤➤Question 2.4
Refer to Note 23 Subsequent Events in the notes to financial statements of the 2016 financial
statement of Techworks Ltd. This note refers to two events which have occurred after 30 June
2016 (but before the signing off of the financial report by the directors).
The two events disclosed in Note 23 are:
• renegotiation of the loan facility (and repayments) in August 2016
• declaration of the dividend by the directors on 17 October 2016.
Explain whether these two subsequent events are adjusting or non-adjusting events under IAS 10.
Dividends declared after reporting date

Dividends may be declared after the end of the reporting period. Paragraph 12 of IAS 10 states
that an entity should not recognise those dividends as ‘a liability at the end of the reporting
period’ even if the dividend was declared from profits derived prior to the reporting date.
This is because such dividends fail the essential characteristic requirement of a present obligation
existing at the reporting date (IAS 10, para. 13). As such, the dividends declared/payable shall be
regarded as a non-adjustable event and be disclosed as a note to the financial statements.
Disclosures
Events after the reporting period are only reflected in the financial statements up to the date of
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authorisation for issue. Therefore, it is important that this date is disclosed together with details
of who gave the authorisation (IAS 10, para. 17).
Adjusting events reflect conditions that existed at the end of the reporting period. As such,
relevant items need to be adjusted in the financial statements. In addition, an entity may receive
information about conditions at the end of the reporting period that then requires an update
of the disclosures relating to these conditions (para. 19). In some instances, this information
will relate to items not reflected in the financial statements—for example, a contingent liability
disclosed in the notes at the reporting date for possible damages that may result from an
in‑progress court action by a disgruntled customer. Subsequent to the end of the reporting
period but prior to the date of issue, evidence from the court case may indicate a strong
likelihood of losing the case. The entity should update the disclosure about the contingent
liability to reflect this new information.
Paragraph 22 of IAS 10 provides several examples of non-adjusting events. If you wish to explore
this topic further you may now read paras 17–22. Please now attempt Question 2.5 to apply your
knowledge of this topic.
➤➤Question 2.5
Venturiac Holdings Ltd’s reporting period ends on 30 June, and the financial statements are
authorised for issue on 31 August. How should the following events be disclosed?
(a) On 30 July, a major drop in the price of shares means that the value of the Venturiac Holding’s
investments has declined by 25 per cent since 30 June.
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(b) A debtor who owed a significant sum of money as at 30 June was declared bankrupt on
18 August.
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(c) A major explosion occurred on 20 July, causing significant losses for the company.
Summary
IAS 1 specifies the components of financial statements (e.g. P&L and OCI, statement of financial
position) and the considerations that must be taken into account when preparing a set of
financial statements. These considerations include:
• compliance with IFRSs to present fairly the financial performance, financial position and
cash flows of an entity
• selection and disclosure of accounting policies
• assessment of whether the entity is a going concern
• use of the accrual basis of accounting
• use of materiality to determine which items should be separately disclosed
• need for consistency from one reporting period to the next
• comparative information.
This module covered the selection and disclosure of accounting policies in some detail. IAS 8
deals with the selection of accounting policies and specifies that management should select
accounting policies that comply with standards and interpretations. Where there is no specific
requirement in a standard or interpretation, accounting policies must be selected and applied so
that the resultant information is relevant and reliable.
IAS 1 contains requirements for the disclosure of accounting policies including:

• a description of the measurement basis or bases used
• a description of accounting policies necessary for an understanding of the financial report
• detailed information where material uncertainties exist as to whether the entity can continue
as a going concern or whether the financial report has been prepared on other than a going
concern basis.
IAS 8 specifies that an entity can only change an accounting policy when this is required by a
standard or interpretation, or the change is necessary to provide reliable and more relevant
information. Where an entity changes an accounting policy because of a new standard or
interpretation, it must apply the transitional provisions of that standard or interpretation.
When there are no transitional provisions in the standard or interpretation, or the entity is
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making a voluntary change in accounting policy, the accounting policy change must be made
retrospectively. That is, IAS 8 requires the entity to:
• adjust the opening balance of each component of equity affected by the change for the
earliest prior period included in the financial statements
• restate any comparative amounts included in the financial statements as if the new policy
had always been applied.
Where an accounting policy change is made, the entity must disclose information—including the
title of the standard or interpretation (if a new standard or interpretation required the change),
the nature of the change, the reasons for the change and the amount of any adjustments made
to the financial statements.
The final section of Part A dealt with IAS 10. The standard identifies two types of events occurring
after the reporting period: adjustable and non-adjustable events.
Where the event provides evidence of conditions existing at the end of the reporting period,
the financial statements must be adjusted to reflect this event. Where the event does not relate
to conditions existing at the end of the reporting period, disclosure in the notes is only required
where the information would affect the decisions of users.
Study guide | 121
Part B: Statement of profit or loss and

other comprehensive income
Introduction
One of the key indicators of a business entity’s performance is its reported profit figure.
Therefore, how profit is determined and the information that is disclosed concerning various
aspects of profit are central accounting issues. IAS 1 deals with these matters.
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Part B discusses the composition of the P&L and OCI, including the components of what
is required to be included in this statement. The concept of ‘comprehensive income’ is
also explained.
Under IAS 1, an entity has the choice of presenting either a single-statement P&L and
OCI or showing this as two statements, namely an ‘income statement’ and ‘statement of
comprehensive income’.
Relevant paragraphs
To achieve the objectives of Part B outlined in the module preview, read the relevant
paragraphs in the following accounting standard. Where specified, you need to be able to
apply these paragraphs:
Subject Paragraphs
Definitions 7
Complete set of financial statements 10A
Statement of profit or loss and other comprehensive income 81A
Information to be presented in the profit or loss section or the statement
of profit or loss 82
Information to be presented in the other comprehensive income section 82A–87
Profit or loss for the period 88–89
Other comprehensive income for the period 90–96
Information to be presented in the statement(s) of profit or loss and other
comprehensive income or in the notes 97–105
Presentation of comprehensive income

IAS 1 requires an entity to prepare and include a P&L and OCI in its financial statements.
Paragraph 10A of IAS 1 requires an entity to present either:

(a) a single statement of profit or loss and other comprehensive income with two sections
presented together, the first section for the profit or loss followed by the second section
for other comprehensive income; or
(b) two statements—a statement of profit or loss (presenting components of profit or
loss) which must be immediately followed by a statement of profit or loss and other
comprehensive income (beginning with the profit or loss and presenting components
of other comprehensive income).
If you wish to explore this topic further you may now read the definitions of ‘profit or loss’,
‘other comprehensive income’ and ‘total comprehensive income’ in para. 7 of IAS 1.
Figure 2.5 illustrates:

• the components of comprehensive income (items of profit or loss and items of other
comprehensive income)
• the relationship of the components to the presentation requirements of IAS 1
• the link between comprehensive income and the statement of changes in equity
(to be discussed in Part C).
Figure 2.5: Components of comprehensive income and their presentation

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Income Other comprehensive Total comprehensive

Less: Expenses income income—changes in equity
= Profit or loss Items of income and other than transactions
Components (excludes other + expense not recognised in = with owners (para. 7)
comprehensive income) profit or loss as required
(para. 7) or permitted by other
IFRSs (para. 7)
Single statement of
profit or loss and other
Presentation comprehensive income
Statement of
option 1: Income
changes in
para. 10A— Expenses
equity
single statement Profit or loss
Other comprehensive income
Total comprehensive income
Separate statement Statement of profit or loss

Presentation of profit or loss and other comprehensive Statement of
option 2: Income income changes in
para. 10A— Less: Expenses Profit or loss equity
two statements Profit or loss Other comprehensive income
Source: Based on IRFS Foundation 2017, IAS 1 Presentation of Financial Statements,

If you wish to explore this topic further you may now read the examples on presenting total
comprehensive income in the ‘Guidance on implementing IAS 1 Presentation of Financial Statements’
(in Part B of the Red Book).
The concept of other comprehensive income

and total comprehensive income
‘Other comprehensive income’ is defined in para. 7 of IAS 1 and comprises items of income and
expense (including reclassification adjustments) that are not recognised in P&L as required or
permitted by other IFRSs.
Study guide | 123
Paragraph 7 of IAS 1 provides examples of income and expense items included in OCI via an
IFRS. For example:
• unrealised foreign exchange gains and/or losses arising from translating the financial
statements of a foreign operation under IAS 21
• unrealised gains and losses on remeasuring financial instruments under IFRS 9
• some revaluation increase and decrease resulting from the revaluation of non-current
assets under IAS 16
• unrealised gains and losses on remeasuring cash flow hedges under IAS 21
• actuarial gains and losses on remeasuring defined benefit plan assets under IAS 19.
This study guide includes the following examples of other comprehensive income:
• changes in the revaluation surplus made in accordance with IAS 16 Property, Plant and
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Equipment (paras 39 and 40)
• gains and losses from remeasuring equity instruments measured at fair value through OCI
in accordance with IFRS 9 Financial Instruments.
Paragraph 88 of IAS 1 requires all income and expense items to be included in the determination
of profit or loss for a reporting period ‘unless an IFRS requires or permits otherwise’. In broad
terms, income and expense items excluded from the P&L (and recorded in OCI) include items:
• arising from the correction of errors or changes in accounting policies in accordance with
IAS 8
• meeting the Conceptual Framework definition of income or expense, but that are required
or permitted to be excluded by the requirements of another IFRS (para. 89).
As discussed in Part A, IAS 8 requires the retrospective application of changes in accounting

policies and the retrospective correction of errors. These items are excluded from the profit or
loss for the current reporting period. Although dependent on the nature of the retrospective
application, the impact on the financial statements in the current period is reflected in the
statement of changes in equity via adjustments to the opening balances of equity items
(often retained earnings).
With regards to non-current asset revaluations, IAS 16 requires an increase in an asset’s carrying
amount due to a revaluation to be recognised in OCI if it is not a reversal of a previous revaluation
decrease of the same asset (IAS 16, para. 39). If it is a reversal of a previous revaluation decrease,
it is to be recognised in P&L only, to the extent that it offsets the previous decrease (IAS 16,
para. 39).
Alternatively, IAS 16 requires a decrease in an asset’s carrying amount due to a revaluation to be

recognised in profit or loss if it is not a reversal of a previous revaluation increase of the same
asset (IAS 16, para. 40). If it is a reversal of a previous revaluation increase, it is to be recognised
in OCI only to the extent it offsets the previous increase (IAS 16, para. 40).
All changes in equity other than contributions by the owners (e.g. the issue of additional shares)
and reductions in equity (e.g. share buy-backs and dividends paid) shall be recognised in the
P&L and OCI.
In the case of contributions by the owners (e.g. the issue of additional shares) and reductions in
equity (e.g. share buy-backs and dividends paid), these transactions will be reflected directly
in the statement of changes in equity rather than in P&L and OCI.
If you wish to explore this topic further you may now read:
• the definition and associated discussion of ‘other comprehensive income’ in para. 7 of IAS 1
• paras 88 and 89 of IAS 1.
IAS 1—disclosures and classification

IAS 1 allows entities a choice in presenting either:
• a single-statement P&L and OCI, or
• two statements (i.e. a separate income statement and a P&L and OCI)
1. Single statement (statement of profit or loss and

other comprehensive income)
Under the first option, an entity will include a single-statement P&L and OCI. Many listed
Australian companies such as Cabcharge, Ten Network Holdings, Flight Centre, The Reject Shop,
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Southern Cross Media Group and the Mirvac Property Group have adopted a ‘single-statement
approach’.
According to para. 81A of IAS 1, this single statement will not only include all items of income
and expenses, which gives the net profit or loss for the period as per para. 81A(a), but also a
second section that contains OCI of the entity (para. 81A(b)).
The total of these two figures gives ‘total comprehensive income for the period’ (para. 81A(c)).
This amount is subsequently transferred to the statement of changes in equity.
In other words:
Total comprehensive = Profit or loss + Other comprehensive

income (after tax) income
Where an entity is presenting a consolidated P&L and OCI, both the consolidated ‘profit or loss’
for the period and the consolidated ‘comprehensive income’ for the period must be allocated
between:
• non-controlling interests
• the parent entity’s owners.
The amounts of the allocations of consolidated profit or loss and consolidated comprehensive
income to each of these groups of shareholders must be presented as separate items (para. 81B).
This requirement will be covered in Module 5, which deals with consolidated financial statements.
IAS 1 also contains disclosure and classification requirements for the P&L and OCI. Next is a
discussion of the following IAS 1 requirements:
• information to be presented in the P&L and OCI
• OCI presentation and disclosures
• separate disclosure of income and expense items
• classification of income and expenses
Information to be presented in the statement of profit or loss and other

In addition to a section for the P&L and a section for OCI, the P&L and OCI must present the
following items:
• ‘profit or loss’ (para. 81A(a))
• ‘total other comprehensive income’ (para. 81A(b))
• ‘comprehensive income for the period, being the total of profit or loss and other
comprehensive income’ (para. 81A(c)).
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Where an entity presents a separate P&L (the two-statement approach), the profit or loss section
is not presented in the statement that presents comprehensive income (para. 81A). That is,
the second statement commences with a single line item for the amount of the profit or loss
for the period.
Where an entity is presenting a consolidated P&L and OCI, both the consolidated ‘profit or loss’
for the period and the consolidated ‘comprehensive income’ for the period must be allocated
between non-controlling interests and the parent entity’s owners.
The amounts of the allocations of consolidated profit or loss and consolidated comprehensive
income to each of these groups of shareholders must be presented as separate items (para. 81B).
This requirement will be covered in Module 5, which deals with consolidated financial statements.
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If you wish to explore this topic further you may now read paras 81A and 81B of IAS 1.
Part 1: Profit or loss

The first half of the single-statement P&L and OCI contains income and expenses.
Paragraph 82 of IAS 1 specifically requires the following line items to be disclosed in the profit or
loss section of a single-statement P&L and OCI or in the P&L if two statements are presented:
• revenue, presenting separately interest revenue calculated using the effective interest
method (para. 82(a))
• gains and losses arising from the derecognition of financial assets measured at amortised
cost (para. 82(aa))
• finance costs (para. 82(b))
• share of the profit or loss of associates and joint ventures accounted for using the equity
method (para. 82(c))
• if a financial asset is reclassified so that it is measured at fair value, any gain or loss
arising from the difference between the previous carrying amount and its fair value at
the reclassification date (as defined in IFRS 9) (para. 82(ca))
• tax expense (para. 82(d))
• a single amount for the total of discontinued operations (see IFRS 5) (para. 82(ea)).
An entity is allowed to include additional line items on the face of the statement that assists
users in gaining an understanding of the entity’s financial performance (para. 85). For example,
an entity could include information about cost of sales and gross profit.
Expenses—nature or function?
Paragraph 99 of IAS 1 requires expenses to be classified either by nature or by function.
Examples of classification by nature or function can be found in paras 102 and 103 of IAS 1.
Classification by nature means an entity aggregates expenses within the profit or loss according
to their nature—for example, depreciation, purchases of materials, transport costs, employee
benefits and advertising costs. Classification by function (also known as ‘cost of sales method’)
classifies expenses according to their function as part of cost of sales or, for example, the sales
or administrative activities.
When the expenses are classified based on the nature of the expense, employee benefit expenses
would be aggregated and presented as a single line item called, for example, ‘employee benefits
expense’, which communicates the nature of the expense to the user of the financial statements.
In contrast, when expenses are classified based on the function of the expense, employee benefit
expenses would be allocated to the respective functions to which the expenses relate (e.g. cost
of sales, marketing expenses, administration expenses), which communicates the function of the
expense to the user of the financial statements.
The choice between nature and function is a matter of professional judgment and will depend
on a number of factors, including the nature of the entity and industry factors (IAS 1, para. 105).
When expenses are classified by function, the entity must disclose, in the notes, information
about the nature of expenses, including depreciation, amortisation expense and employee
benefits expense (para. 104).
Furthermore, IAS 1 prohibits the presentation of extraordinary items in the ‘statement(s)

presenting profit or loss and other comprehensive income or in the notes’ (para. 87). Previously,
an item of income or expense was regarded as extraordinary if it was outside the ordinary
activities of the entity and not recurring in nature. These extraordinary items were then presented
separately from the profit or loss. Entities often abused this provision and applied the term
‘extraordinary’ to any major write-downs or losses (e.g. bad news was extraordinary). For this
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reason, IAS 1 now prohibits such abuse.
Separate disclosure of material income and expense items

Paragraph 82 of IAS 1 requires certain information to be presented on the face of the P&L
and OCI, with separate disclosures for items such as finance costs expense and tax expense.
The module will now focus on some additional IAS 1 disclosures and classification requirements.
An item is material if it influences the economic decisions taken by users of financial statements
(IAS 1, para. 7, definition of ‘material’). To ensure that financial report users fully understand the
financial performance of an entity, there may be specific income and expenses that are material
and, therefore, require separate disclosure of the nature and amount of the item (para. 97).
The determination of whether an item is material is a matter of professional judgement based
on an analysis of the significance of that item relative to other items (either due to the amount
or the nature of that item). Paragraph 98 of IAS 1 provides examples of circumstances that
would require separate disclosures of income and expenses, including write-downs of assets
to recoverable amount, restructuring of the activities of an entity, or disposals of property,
plant or equipment.
• paras 82–87 and paragraph 98 of IAS 1
• IFRS 15, Appendix A: Defined terms to compare the definitions of income and revenue.
Part 2: Other comprehensive income

The second half of the single-statement P&L and OCI contains ‘other comprehensive income’.
Paragraph 82A of IAS 1 specifies the requirements for the presentation of OCI. First, the nature
and amount of each item of OCI must be presented separately, including the share of OCI
of equity-accounted associates and joint ventures. Second, each item must be grouped into
those that:
• will not be reclassified subsequently to profit or loss; and
• will be reclassified subsequently to profit or loss when specific conditions are met
(IAS 1, para. 82A).
Whether an item of OCI has to be classified subsequently to the profit or loss is determined by
the IFRS relevant to accounting for that particular item. Reclassification of items of OCI will be
dealt with shortly.
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Paragraphs 90–96 of IAS 1 specify additional requirements for OCI in relation to:
• the disclosure of income tax relating to each component
• the disclosure of reclassification adjustments.
These disclosures can be included either in the P&L and OCI or in the notes.
In relation to income tax, the items of OCI may be presented in the P&L and OCI either:
• net of related tax, or
• before tax with an aggregate amount of tax for all items (para. 91).
If the aggregate tax approach is adopted, the tax has to be allocated between the two groupings
of items of OCI—that is, between items that will be subsequently reclassified to the profit or loss
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and those items that will not be reclassified to the profit or loss.
When the ‘net of tax’ approach is used, the amount of income tax relating to each item of OCI
will appear either in the P&L and OCI or in the notes. The ‘aggregate tax’ approach requires
disclosure of income tax for each component of OCI in the notes.
If you wish to explore this topic further you may now read paras 90 and 91 of IAS 1. Also read
the illustrative P&L and OCIs in the ‘Guidance on implementing IAS 1 Presentation of Financial
Statements’ (in Part B of the Red Book) that demonstrate the two acceptable approaches to dealing
with the disclosure of income tax for components of OCI.
Some IFRSs (e.g. IAS 21 The Effects of Changes in Foreign Exchange Rates and IFRS 9 Financial
Instruments) permit items previously included in OCI to be reclassified to the profit or loss
upon particular events. These are referred to as ‘reclassification adjustments’ (IAS 1, para. 93).
For example, the unrealised gains or losses on the translation of the financial statements of
a foreign operation are recognised in OCI and accumulated in equity (via a ‘foreign currency
translation reserve’) until the foreign operation is disposed of. Upon disposal, IAS 21 requires the
cumulative amount of exchange differences to be reclassified from equity (OCI) to the profit or
loss (IAS 21, para. 48).
IAS 1 requires this type of IAS 21 reclassification adjustment to be separately disclosed along with
the related income tax (IAS 1, paras 90 and 92). Until disposal, the gains or loss on translation of
the financial statements of the foreign operation would be recognised in OCI (and reflected as a
change in the related equity item).
When the accumulated gain or loss is reclassified to P&L, OCI is adjusted to avoid including
the total gain or loss of the current and preceding reporting periods in total comprehensive
income twice. That is, it cannot appear in both OCI and in the profit or loss over the period of
the transaction.
What happens to the totals in the statement of profit or loss and other
comprehensive income?
Both the net profit after income tax figure and the ‘other comprehensive income’ figures are
transferred to the statement of changes in equity.
The table below illustrates this concept.
Net profit after income tax Transferred to the ‘retained profits’ column in the statement of changes
in equity
Items included in other Transferred to the ‘reserves’ column in the statement of changes in equity
For example, if there was a revaluation of an asset, this would be
transferred to the ‘reserves’ column in the statements of changes in equity
and end up in the ‘revaluation surplus’ as per IAS 16 para. 39.
Similarly, any foreign exchange gains or losses arising in respect of

foreign operations would be transferred to the ‘reserves’ column in the
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statements of changes in equity and end up in the ‘foreign currency

translation reserve’ as per IAS 21.
➤➤Question 2.6
Refer to Section 8 of the ‘Case study data’. Prepare a single P&L and OCI for Webprod Ltd in
accordance with paras 10A, 81A and 82 of IAS 1.
Notes:
• There was a revaluation increase of buildings by $150 000, and a revaluation decrease of the
land by $230 000. This reduced the balance of revaluation surplus of Webprod Ltd by $80 000.
• For the purposes of this module, ignore any tax effects of revaluations because this topic is
not dealt with until Module 4.
• Question 2.8 will consider an expanded income statement, after classification and other
disclosures have been discussed.
➤➤Question 2.7
(a) Refer to the P&L and OCI prepared in answering Question 2.6. Explain whether the revaluation
loss included in OCI could result in a ‘reclassification adjustment’ in future reporting periods.
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(b) Where the financial statements of a foreign operation are translated for inclusion in the
financial statements of a reporting entity, the exchange differences arising from the translation
are initially recognised in OCI and accumulated in equity. On the disposal of the investment in
the foreign operation, the total foreign currency exchange difference accumulated in equity
over the life of the foreign operation is recognised in the profit or loss.
Assume that, at the date of disposal of an investment in a foreign operation, an entity had
recognised accumulated exchange difference gains net of tax through OCI of $7000 (pre-tax
of $10 000). Of the accumulated exchange difference gains, $2800 (pre-tax of $4000) related
to the current reporting period.
Using the net of tax approach, illustrate how the preceding information would be disclosed in
the P&L and OCI for the reporting period when the disposal of the investment in the foreign
operation occurred.
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2. Two statements (statement of profit or loss and a statement

of profit or loss and other comprehensive income)
Under the second option, an entity prepares two separate statements, being:
• a P&L
• a P&L and OCI
The only difference between the ‘single-statement approach’ and the ‘two-statement approach’
is that instead of showing both sections in one combined statement, there are two separate
statements.
In a two-statement approach, the P&L includes the entity’s incomes and expenses for the period
ending with the line ‘profit or loss for the period’ (after tax). The P&L and OCI starts with this line
and adds each item of OCI.
As in the case of the single-statement approach, total comprehensive income is the sum
of profit or loss for the period (after income tax) plus OCI.
Many listed Australian companies such Harvey Norman Holdings, Wesfarmers, Qantas,
Virgin Australia, Woolworths, Telstra and JB Hi-Fi have adopted a two-statement approach.
If you wish to explore this topic read:

• paras 99–105 of IAS 1, which discuss and illustrate the classification of expenses in more detail
• the examples for the presentation of P&L and OCIs in the ‘Guidance on implementing IAS 1
Presentation of Financial Statements’, which illustrate the classification of expenses by function
and nature respectively (in Part B of the Red Book)
• paras 110 and B87–89 of IFRS 15, which contain the disclosure and classification requirements
for revenue.
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➤➤Question 2.8
(a) Refer to Section 8 of the ‘Case study data’. Explain which items you would consider for
separate disclosure in the notes to the financial statements in accordance with para. 97 of
IAS 1.
(b) Refer to Section 8 of the ‘Case study data’. Prepare a single P&L and OCI for Webprod Ltd
in accordance with the presentation, disclosure and classification requirements of IAS 1.
Assume Webprod Ltd classifies expenses according to function.
Tips on how to analyse the statement of profit

or loss and other comprehensive income
The purpose of the P&L and OCI is to summarise the entity’s income and expenses during the
reporting period. However, it also shows unrealised gains and losses arising from transactions
that result in increases or decreases to equity other than contributions or withdrawals by the
owners. The figures comprising total comprehensive income are transferred to the various
reserves in the statement of changes in equity.
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Some tips on how to read, analyse and interpret the P&L and OCI are summarised below.
1. Review the components of income. Has there been an increase or decrease in total revenue
from the previous reporting period? What are the main drivers for this increase or decrease?
Refer to the notes to the accounts for further information about income.
2. Review the components of expenses. How does the entity classify its expenses (nature or
function)? Has there been an increase or decrease in expenses from the previous reporting
period? What are the main drivers for this increase or decrease? Are there any notable large
movements or any one-off material (non-recurring) expenses, such as impairment losses.
Refer to the notes to the accounts for further information about expenses.
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3. Review the profit result for the period. Has the entity made a profit or a loss? How does
this result compare to the previous reporting period? What are the main drivers for the
increase or decrease in profit?
4. Review the OCI result. Are there any significant changes in items of comprehensive income
(e.g. asset revaluations) from the previous reporting period? What are the main drivers for
these changes?
5. Overall performance. In your opinion, how well is the company performing? Did it perform
better or worse than the previous reporting period?
Summary
• the measurement of profit or loss and OCI for a period
• disclosures to be made in the P&L and OCI.
IAS 1 adopts an all-inclusive view of comprehensive income and provides for separate disclosure
of a number of material items. In relation to the profit or loss, these items include finance costs,
tax expense and profit or loss. For OCI, each component must be separately disclosed along
with the income tax relating to the component and any reclassification adjustments.
You may wish to explore this topic further and review the illustrative P&L and OCI (which are not part
of the standards) that are included in the ‘Guidance on implementing IAS 1 Presentation of Financial
Statements’ (in Part B of the RedBook).
Part C: Statement of changes in equity

Introduction
In addition to a P&L and OCI, IAS 1 requires a set of general purpose financial statements to
include a statement of changes in equity, which discloses:
• the changes to each equity item arising from comprehensive income, transactions with
owners and retrospective adjustments in accordance with IAS 8
• a reconciliation between the opening and closing amounts of each component of equity
for the period.
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Part C discusses the composition of the statement of changes in equity, including the
components of what is required to be included in this statement.
Relevant paragraphs
To achieve the objectives of Part C outlined in the module preview, read the relevant
Subject Paragraphs
Information to be presented in the statement of changes in equity 106
Information to be presented in the statement of changes in equity or in the notes 106A –110

Disclosures of changes in equity
A statement of changes in equity should explain and reconcile the movement in net assets
of an entity over a reporting period. The two primary sources of change in an owner’s equity
(and therefore net assets) are:
• ‘the transactions with owners in their capacity as owners’
• ‘the total income and expenses ‘generated by the entity’s activities’ (para. 109).
The statement of changes in equity requires disclosure of the total comprehensive income and
its impact on each relevant equity component, as detailed information relating to income
and expenses is contained in the P&L and OCI.
Paragraph 106 of IAS 1 requires each entity to present a statement of changes in equity,
which contains the following disclosures:
• total comprehensive income (allocated between non-controlling interests and owners of
the parent—discussed in Module 5)
• the effect on each component of equity of any retrospective adjustments required by IAS 8
• a reconciliation between the opening and closing balance of each component of equity,
with separate disclosure of changes from profit or loss, OCI and transactions with owners.
For each component of equity affected by OCI, an analysis of the item must be provided either
in the statement of changes in equity or in the notes (para. 106A). This would include details
such as the source of the OCI; tax relating to the items involved; and any non-controlling interest
portion deducted (not relevant in Module 2).
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Further, para. 107 requires disclosures of the amount of dividends recognised as distributions
to owners during a reporting period and the related dividend per share. Information relating to
dividends can be disclosed either in the statement of changes in equity or in the notes.
A typical tabular format for the statement of changes in equity could look like this:
Share capital Reserves Retained profits Total
Opening balance Opening balance Opening balance Opening balance (sum

of opening balances)
+ Issue of share capital + Transfers in +/– Net profit (loss) after

income tax (from income
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statement)
+ Share options +/− Gains/(losses) on +/– OCI (from the statement

exercised property revaluations of comprehensive income)
+/– Restatement of
prior period balances
(whether due to a
change in accounting
policy, adoption of new
accounting standard or a
prior period material error)
− Share buybacks/ +/− Exchange − Dividends declared

return of capital differences on
translating foreign
operations
= Closing balance = Closing balance = Closing balance Closing balance (sum

of closing balances)
• paras 106–110 of IAS 1
• the example statement of changes in equity in the ‘Guidance on implementing IAS 1
Presentation of Financial Statements’ (in Part B of the Red Book), including the notes,
which analyse the changes to equity items as a result of OCI.
➤➤Question 2.9
Refer to Sections 1 and 8 of the ‘Case study data’. Prepare a statement of changes in equity in
accordance with paras 106 and 107 of IAS 1 in the column format that reconciles the opening and
closing balances of each component of equity as illustrated in the ‘Guidance on implementing
IAS 1 Presentation of Financial Statements’ (in Part B of the Red Book).
Summary
In addition to reconciling the opening and closing balances of each component, the statement
of changes in equity discloses all changes to each component of equity for a reporting period.
This information enables the user to understand why the net assets of an entity have increased
or decreased, how much of the change is from transactions with owners and how much relates to
comprehensive income.
Part D: Statement of financial position

Introduction
In addition to being interested in the financial performance of an entity, financial statement
users are also interested in its financial position. Information about the financial position is
contained in the statement of financial position or, as it is often referred to, the balance sheet.
IAS 1 prescribes:
• the presentation requirements for assets and liabilities
• the disclosure requirements for a statement of financial position and its components.
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Part D discusses the composition of the statement of financial position, including the
components of what is required to be included in this statement.
Relevant paragraphs
To achieve the objectives of Part D outlined in the module preview, read the relevant
Subject Paragraphs
Information to be presented in the statement of financial position 54–59
Current/non-current distinction 60–65
Current assets 66–68
Current liabilities 69–76
Information to be presented either in the statement of financial position or in the notes 77–80A
Format of the statement of financial position

IAS 1 does not stipulate a strict format for the statement of financial position.
However, paras 54–59 of IAS 1 prescribe the minimum line items that must be presented on
the face of the statement of financial position.
These line items are summarised in Table 2.1.

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Table 2.1: M
inimum headings required on the face of the statement
of financial position
Assets Liabilities Equity
Cash and cash equivalents Trade and other payables Issued capital
Trade and other receivables Financial liabilities Reserves
Inventories Provisions Retained earnings
Financial assets Current tax liabilities Non-controlling interests
Non-current assets classified Liabilities directly associated
as held for sale with non-current assets
Investments accounted for classified as held for sale
using the equity method Deferred tax liabilities
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Property, plant and equipment
Investment property
Intangible assets
Biological assets
Current tax assets
Deferred tax assets
The above headings are the minimum disclosures required by IAS 1. An entity is entitled
and permitted to add additional line items on the face of the statement of financial position
(e.g. goodwill, deferred revenue etc.).
If you wish to explore this topic further you may now, read paras 54–59 of IAS 1. Note that IAS 1
does not require any particular format for a statement of financial position. The chosen format should
not impair the understanding of the information. Also refer to the illustrative statement of financial
position in the ‘Guidance on implementing IAS 1 Presentation of Financial Statements’ (in Part B
of the Red Book).
Presentation of assets and liabilities

IAS 1 permits two bases for the presentation of assets and liabilities. The traditional current/
non‑current categories can be used, or alternatively, all the assets and liabilities can be presented
in order of liquidity.
The liquidity basis can be used only where it provides reliable and more relevant information than
the current/non-current basis (IAS 1, para. 60). For example, a financial institution would list its
assets and liabilities in order of liquidity, as the solvency of such institutions is critical, and they
do not provide services within an operating cycle (para. 63). Regardless of which approach
is adopted, para. 61 of IAS 1 requires all entities to disclose separately any amounts due to
be settled or recovered in less than 12 months and after 12 months if an item combines such
amounts due or receivable.
If you wish to explore this topic further you may now read paras 60–65 of IAS 1, which confirm and
expand on this discussion. You may also wish to read ‘Guidance on implementing IAS 1 Presentation
of Financial Statements’ (in Part B of the Red Book), which provides an example of the current/
non‑current presentation.
Current assets and current liabilities

Paragraph 66 of IAS 1 defines a current asset as an asset which satisfies any one of the
following criteria:
• It is expected to be realised in, or is intended for sale or consumption in, the entity’s
normal operating cycle.
• It is held primarily for trading purposes.
• It is expected to be realised within 12 months after the reporting period.
• It is cash or a cash equivalent (as defined in IAS 7), provided there is no restriction on its use
by the entity until 12 months after the reporting period.
‘The operating cycle of an entity is the time between the acquisition of assets for processing and
their realisation in cash or cash equivalents’ (IAS 1, para. 68). If an entity’s operating cycle is not
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clearly identifiable, it is assumed to be 12 months (para. 68).
All other assets are to be classified as non-current assets, including tangible, intangible and
long‑term financial assets. The term ‘non-current assets’ is recommended, but IAS 1 permits
other descriptions to be used for this category, such as ‘fixed assets’ or ‘long-term assets’
(para. 67).
Paragraph 69 of IAS 1 defines a current liability as a liability that satisfies any one of the
following criteria:
• It is expected to be settled in the entity’s normal operating cycle.
• It is held primarily for trading purposes.
• It is due to be settled within 12 months after the reporting period.
• There is no unconditional right of deferring settlement beyond 12 months after the reporting
period. (Liabilities that could potentially require settlement by the issue of equity instruments
are not covered by this requirement, as settlement must involve cash or other assets.)
Liabilities that do not satisfy the preceding criteria are classified as non-current liabilities (para. 69).
Current assets and current liabilities include those assets or liabilities that are expected (even if
not required) to be consumed, realised or settled within 12 months after the end of the reporting
period (IAS 1, paras 66 and 69). The period can be longer where the operating cycle is longer
than 12 months. For example, a long-term construction (large buildings, bridges or airports)
entity is likely to have an operating cycle longer than 12 months.
Entities normally include the portion of long-term, financial liabilities due for repayment within
12 months as a current liability. Paragraph 72 of IAS 1 requires entities to continue to show this
amount as a current liability even if
• the original term was for a period longer than 12 months; and
• an agreement to refinance, or to reschedule payments, on a long-term basis is completed after
the reporting period and before the financial statements are authorised for issue.
If the agreement to refinance was made after the reporting date, then it does not represent
conditions that existed at the reporting date, and therefore, the amount is still current at that
date. However, the agreement may result in a disclosure in the notes as a non-adjusting event in
accordance with IAS 10.
If an entity has the contractual right (i.e. discretion under an existing loan facility) to refinance an
obligation for at least 12 months after the reporting period and expects that this will happen,
the obligation is classified as non-current even if it is due within 12 months. If the entity has no
such discretion to refinance, the obligation is classified as current (IAS 1, para. 73).
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In some instances, entities may breach loan conditions that cause an obligation to become
due on demand. The obligation is regarded as current even if the lender agrees not to demand
repayment after the reporting period (IAS 1, para. 74). However, before the end of the reporting
period, if the lender comes to an agreement with the entity that the lender will not demand
repayment for at least 12 months after the reporting period, the obligation can be classified as
non-current (IAS 1, para. 75).
If you wish to explore this topic further you may now read paras 66–76 of IAS 1, which discuss the
current/non-current presentation in more detail. In particular, note the events that would qualify
for disclosure as non-adjusting events in accordance with IAS 10 Events after the Reporting Period
(IAS 1, para. 76).
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Disclosures in the notes to the statement
Many line items contained in the statement of financial position require additional subclassifications
and disclosures, usually in the notes, as a result of other accounting standards (IAS 1, para. 77).
Furthermore, although IAS 1 prescribes disclosures to appear on the face of the various
financial statements, it does not prescribe detailed disclosures for each of the various line
items. For example, para. 54(g) requires that inventories be disclosed as a separate line item
on the face of the statement of financial position. However, the detailed requirements relating
to the disclosure of inventories in the notes to the accounts can be found in para. 36 of
IAS 2 Inventories.
If you wish to explore this topic further you may now read IAS 1, para. 58, which is relevant in the
context of additional disclosures, and paras 77 and 78 of IAS 1.
Paragraphs 79 and 80 of IAS 1 specify additional disclosures for equity items, including shares
issued, rights attaching to shares and details of reserves. Some items listed in para. 79, such as
authorised capital, are not relevant to all jurisdictions (e.g. Australia). Finally, para. 137 of IAS 1
requires disclosure (in the notes to the financial statements) of information relating to dividends
not recognised.
If you wish to explore this topic further you may now read paras 79, 80 and 137 of IAS 1.
➤➤Question 2.10
Refer to Section 8 of the ‘Case study data’.
Prepare a statement of financial position for Webprod Ltd. You may want to refer to para. 54 of
IAS 1 if you need to review the required line items. In addition, prepare notes to the statement
of financial position that:
• illustrate the composition of the items disclosed in the statement of financial position
• satisfy any relevant disclosure requirements. If you need to review the requirements, refer to
para. 79 of IAS 1.
Tips on how to analyse a statement

The purpose of the statement of financial position is to summarise an entity’s assets, liabilities
and equity. The format of the statement of financial position is to disclose the entity’s assets
and liabilities according to a current/non-current classification. The equity figures in the
statement of changes in equity flow through to the equivalent lines in equity at the end of
the statement of financial position.
Some tips on how to read, analyse and interpret the statement of financial position are
summarised below.
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1. Review the value of total assets. Have total assets increased or decreased from the
previous reporting? What are the drivers behind this increase or decrease? If total assets are
increasing, this indicates that the financial position has expanded (grown). Has the change
been primarily as a result of changes in current assets or non-current assets?
2. Review the value of total liabilities. Have total liabilities increased or decreased from the
previous reporting? What are the drivers behind this increase or decrease? If total liabilities
are increasing, this indicates that the entity has taken on more debt and has increased its
gearing (leverage). Has the change been primarily as a result of changes in current liabilities
or non-current liabilities?
3. Review the value of total equity (or net assets). Is total equity positive? If so, this indicates
that the company is a going concern. Has total equity increased from the previous reporting
period? If so, this indicates that the entity’s financial position has grown. The stage of the
business' life cycle will also impact on this figure. More mature businesses are likely to have
greater amount of retained profits, whereas start-ups may experience losses in the first years
of trading.
4. Analyse the relationship between current assets and current liabilities. This is an
indication of the company’s liquidity position or the entity’s ability to be able to pay its
short-term debts as and when they fall. Are current assets greater than current liabilities?
The general rule of thumb for the current ratio is 2:1. This means that ideally current assets
should be approximately two times larger than current liabilities.
In reviewing a statement of financial position of a particular entity, it is always important to

identify and understand the risks of each asset. For example, in the case of a retailer, it is likely
that inventories will be the largest asset on the balance sheet. In this case, the risk is one of
obsolescence and slow-moving stock.
In the case of an entity that has acquired businesses over the years and those with significant
goodwill and brand names, the impairment of intangibles is likely to be the most significant risk
or concern.
Analyse the relationship between non-current liabilities and non-current assets. This provides an
indication of the entity’s gearing (leverage) position. Is the entity highly geared or lowly geared?
If the entity is highly geared (more debt than assets), this may limit the entity’s ability to borrow
additional funds to fund expansion or capital replacement requirements. If the entity has low
gearing, it may be in a good position to borrow monies from banks and financial institutions to
fund expansion.
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Summary
• the presentation of assets and liabilities
• disclosures in the statement of financial position.
Assets and liabilities must be presented on a current/non-current basis, except where a liquidity
presentation provides information that is more relevant and reliable. Where the current/
non-current classification is used, a 12-month period after the reporting period or the entity’s
operating cycle can be used to identify current assets and liabilities.
IAS 1 contains disclosure requirements, including items that must appear on the face of the
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statement of financial position.
Part E: IAS 7 Statement of Cash Flows

Introduction
Part E discusses the composition of the statement of cash flows, including the format and
presentation of the statement of cash flows, as well as the various cash flows that are required
to be disclosed when presenting the statement.
According to para. 10(d) of IAS 1, an entity is required to include a statement of cash flows in its
financial statements. The content and format of a statement of cash flows is governed by IAS 7.
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The objective of the statement of cash flows is to show the movement in both an entity’s cash and
cash equivalents over the reporting period. Information about an entity’s cash flows is considered
useful in providing users of the financial statements with a basis to assess the entity’s ability to
generate cash flows and its needs to utilise those cash flows (IAS 7, para. Objective).
Relevant paragraphs
To achieve the objectives of Part E outlined in the module preview, read the relevant
IAS 7 Statement of Cash Flows:
Subject Paragraphs
Scope 1–3
Benefits of cash flow information 4–5
Definitions 6
Cash and cash equivalents 7–9
Presentation of a statement of cash flows 10–17
Reporting cash flows from operating activities 18–20
Reporting cash flows from investing and financing activities 21
Reporting cash flows on a net basis 22–24
Interest and dividends 31–34
Taxes on income 35
Non-cash transactions 43
Changes in liabilities arising from financing activities 44A–E44E
Components of cash and cash equivalents 45
Other disclosures 48–52
Assumed knowledge
You should consult the ‘IAS 7 Statement of Cash Flows’ assumed knowledge review located at
the end of this module to check your understanding of the assumed knowledge for Part E. If you
need further assistance with the assumed knowledge, you should consult the latest edition of an
appropriate financial accounting text, such as:
• Henderson, S., Peirson, G. et al., Issues in Financial Accounting, Pearson, Melbourne
• Hoggett, J., Edwards, L. et al., Financial Accounting, John Wiley & Sons, Brisbane.
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Information to be disclosed
A statement of cash flows, prepared in accordance with IAS 7, must be included in a set of
financial statements (IAS 7, para. 1) for each period for which financial statements are presented.
The statement of cash flows discloses separately:

• cash inflows and outflows for the reporting period concerned (paras 18 and 21); for example,
an entity must disclose proceeds from borrowings separately from outflows for repayments
of borrowings rather than report the net cash flow related to borrowings. However,
as discussed below, certain cash flows may be presented on a net basis in accordance
with paras 22 and 24 of IAS 7
• the amounts of cash and cash equivalents at the beginning and end of the reporting period.
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Reporting cash flows on a net basis
Paragraphs 22 to 24 of IAS 7 outline the circumstances and provide examples of situations where
cash flows can be reported on a net basis. These may include:
• ‘cash receipts and payments on behalf of customers’ (para. 22(a)), such as the acceptance
and repayment of demand deposits by banks
• items where ‘the turnover is quick, the amounts are large, and the maturities are short’
(para. 22(b)), such as advances for and repayments of principal amounts relating to credit
card customers.
If you wish to explore this topic further you may now read paras 23 and 23A of IAS 7, which contain
examples of cash flows that can be reported on a net basis.
Also relevant is para. 24 of IAS 7, which deals with the additional items of cash flows that may be
presented on a net basis by a financial institution.
Other information to be disclosed in the statement of cash flow

Several other items of information must be disclosed in the statement of cash flows. These cash
flow items include interest and dividends, income taxes and loss of control of subsidiaries.
They are discussed in IAS 7, paras 31, 35, 39 and 40.
Investing and financing transactions that do not require the use of cash (or cash equivalents)
are excluded from a statement of cash flows (IAS 7, para. 43). For example, an entity may acquire
a block of land by issuing shares. Although this involves the acquisition of an asset, it does
not result in a cash outflow and, therefore, will not be captured in the statement of cash flows.
However, these transactions are required to be disclosed in the notes to the statement of cash
flows (IAS 7, para. 44).
As of 1 January 2017, an entity is also required to disclose changes in liabilities arising from
financing activities, including both changes arising from cash flows and non-cash changes
(IAS 7, para. 44A). The purpose of this amendment is to ‘enable users of financial statements to
evaluate changes in liabilities arising from financing activities’ (IAS7, para. 44A). Liabilities arising
from financing activities are those whose cash flows were, or whose future cash flows will be,
classified as financing activities in the statement of cash flows (IAS 7, para. 44C). The classification
of cash flows is further discussed below. IAS 7 para. 44D states that one way to fulfil the new
disclosure requirement is to provide a reconciliation between the opening and closing balances
in the statement of financial position for liabilities arising from financing activities. This would
include changes arising from cash flows, as well as non-cash changes such as those arising from
obtaining or losing control of subsidiaries or other businesses, the effect of changes in foreign
exchange rates, changes in fair values, and other changes (IAS 7, para. 44B).
An entity is also required to disclose a reconciliation of cash and cash-equivalent amounts in

the statement of cash flows with the equivalent items reported in the statement of financial
position (IAS 7, para. 45).
Paragraphs 48 and 49 of IAS 7 require an entity to disclose the amount of significant cash
and cash-equivalent balances held by the entity that are not available for use by the group;
for example, there may be exchange controls or legal restrictions in place. This disclosure is
important as it allows users to make informed decisions regarding the liquidity of an entity.
If you wish to explore this topic further you may now read the illustrative examples of IAS 7 (in Part B
of the Red Book) to gain an overview of the suggested structure of the statement of cash flows and
the additional information that is required to be presented in the financial statements.
MODULE 2
Classification of cash flows

According to para. 10 of IAS 7, cash flows (both inflows and outflows) must be classified as
arising from:
• operating cash flows
• investing cash flows
• financing cash flows.
Figure 2.6: Classification of cash flows
Cash flows = Operating + Investing + Financing
Cash revenues Movements in Movements in debt

less cash expenses non-current assets and and equity
(i.e. cash profit) other investments
Operating cash flows

Operating cash flows are discussed in paras 13–15 of IAS 7. These cash flows relate to the
principal revenue-producing activities of the entity.
They typically include receipts from customers, receipts from government grants, fees,
commissions as well as cash payments to suppliers and employees, borrowing costs (interest)
paid and income taxes paid. Examples of cash inflows and outflows from operating activities are
shown in Table 2.2.
Table 2.2: Examples of cash inflows and outflows from operating activities
Cash inflows Cash outflows
• Receipts from customers (cash sales) • Payments to suppliers and employees

• Insurance proceeds (cash expenses)
• Grants • Borrowing costs (interest paid)
• Commissions • Income tax paid
• Other operating receipts • Other operating payments

Study guide | 143
Interest paid and dividends received are usually regarded as an operating cash inflow for
financial institutions (IAS 7, para. 33).
However, there is ‘no consensus on the classification of these cash flows for other entities’
(IAS 7, para. 33). An entity may elect to classify items as follows:
• Interest paid may be classified as either an operating cash outflow or a financing cash outflow
(IAS 7, para. 33).
• Interest and dividends received may be classified as either operating cash inflows or investing
cash inflows (IAS 7, para. 33).
• Dividends paid may be classified either as a financing cash outflow or an operating cash
outflow (IAS 7, para. 34).
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Consistent with IAS 7, this module recognises interest paid (borrowing costs) as an operating
cash outflow, interest received as an investing cash inflow (Table 2.3), and dividends paid as
a financing cash outflow (Table 2.4).
Investing cash flows

Investing cash flows are discussed in para. 16 of IAS 7. Cash flows from investing activities
typically include the purchase and sale of non-current assets.
Most investing cash inflows and outflows will come from analysing the movements in the
non‑current assets accounts in the balance sheet.
Examples of cash inflows and outflows from investing activities are shown in Table 2.3.
Table 2.3: Examples of cash inflows and outflows from investing activities
• Proceeds from the sale of property, • Purchase of property, plant and equipment
plant and equipment • Purchase of equity (e.g. shares) or debt
• Proceeds from the sale of investments instruments in other entities for investment
• Interest received • Loans made to other entities
• Dividends received
Financing cash flows

Financing cash flows are discussed in para. 17 of IAS 7. Financing cash flows relate to changes in
the financing activities of the entity (i.e. movements in debt and equity).
Cash flows from financing activities typically include proceeds from borrowings, repayment of
borrowings and the proceeds from the issue of shares.
Table 2.4: Examples of inflows and outflows from financing activities
• Proceeds from the issue of shares • Dividends paid

• Proceeds from borrowings • Repayment of borrowings

Example 2.4: Illustrative example of a statement of cash flows

for the reporting period ended 30 June 20X7
Zhivago Holdings Pty Ltd
$
Cash flows from operating activities (IAS 7, paras 10, 14, 18)
Receipts from customers 831 083
Payments to suppliers and employees (776 276 )
Interest paid (1 545 )
Income tax paid (IAS 7, para. 35) (6 467 )
Net cash flows from operating activities 46 795
Cash flows from investing activities (IAS 7, paras 10, 16, 21)
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Interest received 57
Proceeds from sale of plant and equipment 231
Purchase of plant and equipment (17 119 )
Net cash flows used in investing activities (16 831 )
Cash flows from financing activities (IAS 7, paras 10, 17, 21)
Proceeds from borrowings 141 000
Repayment of borrowings (154 000 )
Dividends paid (IAS 7, para. 31) (7 210 )
Net cash flows used in financing activities (20 210 )
Net increase in cash and cash equivalents 9 754

Cash and cash equivalents at the beginning of the period 7 572
Cash and cash equivalents at the end of the period 17 326
Common methods adopted on how to prepare

a statement of cash flows
The P&L and OCI and statement of financial position are prepared under accrual accounting
concepts. Put simply, the basic aim of a statement of cash flows is to convert the figures prepared
under accrual accounting concepts to what they would be if they were prepared on a cash basis.
A statement of cash flows involves making adjustments from accrual-based information,

de‑accruing the figures and converting them to cash-based figures. In other words, the purpose
of the statement of cash flows is to determine the cash movements during the financial year.
There are three common methods used to prepare a statement of cash flows. These methods
include:
1. the worksheet method (typically prepared in a spreadsheet tool such as Excel™)
2. the formula method
3. the ‘T’ account reconstruction method.
The assumed knowledge for this module is that participants are able to prepare a simple
statement of cash flows. The questions and answers in ‘Module 2: Assumed knowledge review’
illustrate the basic principles to be used when preparing a statement of cash flows.
Because the underlying data are relatively simple, the calculations and the statement of cash
flows have been completed without the aid of a worksheet. However, in more complicated
situations, a worksheet is considered a useful means of organising the necessary procedures.
For the purposes of this module, the formula method will be used in preparing the statement
of cash flows.
Study guide | 145
Formula method
The following is a brief summary of the formulas necessary to determine individual lines in the
statement of cash flows. Once again, it needs to be remembered that the figures in the financial
statements are prepared under accrual accounting principles, while the statement of cash flows is
based on cash movements (i.e. cash inflows and outflows) during the reporting period.
Some of the more common formulas used to determine cash flows include:
Receipts from customers:
Opening balance of + Sales revenue − Bad debts − Closing balance of
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trade receivables written off † trade receivables

†
To determine the amount of bad debts written off, the following formula is relevant:
Bad debts written off:
Opening balance of + Doubtful debts expense − Closing balance of

allowance for doubtful debts (from P&L) allowance for doubtful debts
Inventory purchased on credit:
Closing balance + Cost of goods − Opening balance

of inventories (from P&L) of inventories
Payments to suppliers and employees:
Opening balance of + Expenses + Inventory purchased − Closing balance

trade payables (from P&L) on credit (from above) of trade payables
Income taxes paid:
Opening balance of + Income tax expense − Closing balance of

income tax payable (from P&L) income tax payable
Purchase of property, plant and equipment (PPE):
Closing balance + Disposals (at cost) − Opening balance

of PPE of PPE
Dividends paid:
Opening balance of + Interim + Final − Closing balance of

final dividend dividend dividend final dividend
payable (liability) payable (liability)
How does a statement of cash flows assist users

of the financial statements?
A statement of cash flows is useful for communicating information about an entity’s liquidity and
solvency. According to paras 4 and 5 of IAS 7, the information provided in a statement of cash
flows may assist users in assessing the ability of an entity to:
• generate cash flows in the future
• meet its financial commitments as they fall due, including the servicing of borrowings
and payment of dividends
• fund changes in the scope and/or nature of its activities
• obtain external finance.
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It has also been suggested by numerous authors that a statement of cash flows is useful for
the following purposes:
• predicting future cash flows (both inflows and outflows)
• evaluating management decisions
• determining the ability to pay dividends to shareholders and repay debt—both interest
and principal—to creditors
• showing the relationship of net profit to changes in the cash balances.
Of course, to assist in a full analysis, it would be more useful to review and analyse the statement
of cash flows over a number of years (e.g. five years). This would enable trends to be analysed.
Consolidated financial statements

A parent entity in a group that is required to prepare a set of consolidated financial statements
will include a statement of cash flows that discloses the cash flows of the group. This segment
does not deal with the complexities of preparing a consolidated statement of cash flows from raw
data. However, please note that:
• consolidated cash flows should be reported net of cash flows among entities comprising
the group
• foreign currency translation is required when a foreign subsidiary is a member of a domestic
group and a consolidated statement of cash flows is to be prepared.
If you wish to explore this topic further you may now read paras 25–28 of IAS 7. Note that these
paragraphs also apply to foreign currency-denominated transactions of domestic reporting entities
and to those of foreign subsidiaries that are members of a domestic group. For the purpose of the
Financial Reporting segment, be aware of the contents of paras 25–28, but you will not be required
to apply these paragraphs to practical problems.
➤➤Question 2.11
It is important to complete all previous case study questions before attempting this question.
Refer to sections 1–5, 7 and 8 of the ‘Case study data’.
Prepare a statement of cash flows and disclosures for Webprod Ltd for the year ended
30 June 20X7, using the direct method in accordance with para. 18(a) of IAS 7. In addition,
prepare a reconciliation between the profit for the period and the cash from operating
activities (the indirect method).
Note: Question 2.11 is a comprehensive question that combines many of the concepts discussed
in this section of the module. You can expect to take several hours to complete the set tasks.
Study guide | 147
Tip: Calculate the cash flows for each of the following activities (preferably in this order).
Cash flows from operating activities 1. Cash received from customers

2. Cash received from grants
3. Cash paid to suppliers
4. Cash paid to employees
5. Borrowing costs
6. Warranties paid
7. Income tax paid
Cash flows from investing activities 8. Interest received

9. Proceeds from sale of factory plant and
equipment
10. Purchase of factory plant and equipment
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11. Loan to director
12. Cash paid for product development costs
Cash flows from financing activities 13. Proceeds from funds borrowed
14. Dividends paid
15. Payment of bank loan
16. Payment of promissory notes
Tips on how to analyse the statement

of cash flows
The purpose of the statement of cash flows is to analyse the movement between the opening
and closing balances of the entity’s cash and cash-equivalent accounts during the reporting
period. The statement of cash flows reveals the various sources of cash inflows and cash outflows
of the entity during the reporting period so that users can assess where the monies are coming
from and where they are being spent.
Some tips on how to read, analyse and interpret the statement of cash flows are summarised below.
1. Review the cash balance at the end of the reporting period. Is this value positive? Is it
greater than or less than the balance at the beginning of the reporting period?
2. Review the cash flows from operating activities. This figure is essentially the entity’s cash
profit figure. Is this value positive? A positive value is a good sign that the entity has made
a cash profit during the reporting period. How does this value compare to the previous
reporting periods’ cash flows from operating activities? If the result for the current period is
higher, this is a good sign as it indicates that the entity’s cash profit has increased.
If the cash profit figure has decreased, this would firstly indicate that the entity has had a cash
loss during the current reporting period. The entity has spent more money on its operating
day-to-day activities than it has received. This is a less positive sign, as all entities should be
looking to make an underlying cash profit from their day-to-day business operations. As a
general rule of thumb, the entity should report a positive cash flow from operating expenses,
and this amount should (in principle) be enough to cover net cash used in investing and
financing activities.
3. Review the cash flows from investing activities (i.e. purchasing and disposing of non‑current
assets and investments). Is this value positive or negative? If negative, this indicates that the
entity has invested in non-current assets. This could mean that the entity is expanding its
operations or that the entity may be in the start-up or growth phase of the business life cycle.
4. Review the cash flows from financing activities (i.e. is the business funding the acquisition
of assets through debt or equity?) Review the increases or decreases in external borrowings.
Has the entity borrowed or paid back funds? Review the increases and decreases in equity.
Has the entity paid dividends or issued more shares to raise capital? How does the payout of
dividends compare to the net cash flow from operating activities? Has the entity paid out a
high percentage of profits to its shareholders, or has it retained the funds to cover operating
costs and repayment of financing arrangements?
MODULE 2
5. Review the net increase or decrease in cash and cash equivalents. Is this value positive or
negative? A positive value indicates that the entity has retained (and banked) funds for the
reporting period. This also indicates that the entity has generated substantial cash profits
from operating activities. This will be particularly pleasing for shareholders who are interested
in the ability of their investment to generate positive returns.
Summary
IAS 7 specifies the requirement for the presentation of a statement of cash flows to be included
in the general purpose financial statements of an entity. The statement is to display information
about cash inflows and outflows from operating, investing and financing activities.
Gross cash flows are to be presented in the statement of cash flows. IAS 7 permits cash flow from
operating activities to be reported on the face of the statement of cash flows using either the
direct or indirect method (although the former is preferred).
Several pieces of information relevant to the operating, financing and investing activities of a
reporting entity are to be separately disclosed. These are to be disclosed in the notes to the
financial statements of which the statement of cash flows forms a part.
Re-read the list of objectives at the beginning of this module and make sure you have mastered
all of these before moving on.
Study guide | 149
Review
In Module 2, the discussion has centred on the issues relating to the presentation of financial
statements and the preparation of the four financial statements: the P&L and OCI, the statement
of changes in equity, the statement of financial position and the statement of cash flows.
The following accounting standards were considered as part of the discussion:
• IAS 7 Statement of Cash Flows
• IAS 10 Events after the Reporting Period
• IAS 34 Interim Financial Reporting
MODULE 2
• IFRS 8 Operating Segments.
Part A discussed the overall considerations in preparing financial statements and the structure
and content of particular financial statements (as contained in IAS 1). As accounting policies
are a key determinant of the content of financial statements, the focus was on the IAS 8
requirements to disclose the accounting policies of an entity and any changes made to such
policies. Part A also discussed how to deal with information that arises from events that occur
in the time between the end of the reporting period and the date the financial statements are
authorised for issue. IAS 10 makes a distinction between events that clarify conditions that
existed at the end of the reporting period (information from such events is incorporated into
the financial statements) and those that indicate conditions after the reporting period (if material,
information about their nature and financial effect is disclosed in the notes).
Part B discussed the P&L and OCI. IAS 1 specifies disclosure requirements for items to be
included in the P&L and OCI. In addition, IAS 1 sets accounting standards for the measurement
of profit (loss) and OCI. Total comprehensive income for a period is based on an ‘all-inclusive’
view of profit. The disclosure requirements of IAS 1 include items such as revenue, finance
costs, tax expense and profit or loss. An illustrative P&L and OCI is included in the ‘Guidance on
implementing IAS 1 Presentation of Financial Statements’.
Part C dealt with the statement of changes in equity. This statement requires the disclosure of
the changes to each equity component arising from comprehensive income, transactions with
owners and retrospective adjustments made in accordance with IAS 8. The statement must
also contain a reconciliation between the opening and closing amount of each equity item for
the period.
Part D considered the statement of financial position. IAS 1 prescribes standards for the
classification of assets and liabilities. In addition, IAS 1 prescribes disclosure requirements
for a statement of financial position. An illustrative statement of financial position is included
in the ‘Guidance on implementing IAS 1 Presentation of Financial Statements’ (in Part B of
the Redbook).
Part E considered the statement of cash flows. IAS 7 requires this statement to display
information about cash flows from operating, financing and investing activities. IAS 7 also
requires the disclosure of several items in the notes to the statement of cash flows, including:
• information about non-cash financing and investing activities
• details of the cash unavailable for use.
MODULE 2
Case study data: Webprod Ltd | 151
Case study data:

Webprod Ltd
MODULE 2
Webprod Ltd, a manufacturer of computer modems, was incorporated on 8 August 20X2.
The company also has two retail outlets through which it markets computer-related products.
The accountant for Webprod Ltd is currently preparing the company’s 20X7 financial statements.
The following sections will be referred to throughout Module 2.
Section 1: Information relating to prior

reporting periods
The statement of financial position of Webprod Ltd as at 30 June 20X6 was as follows:
$ $
Current assets
Cash at bank† 6 713
Trade receivables 467 840
Less: Allowance for doubtful debts (15 600 ) 452 240
Secured loan to director 22 000
Raw materials (at cost) 62 500
Work in process (at cost) 108 400
Finished goods—manufactured modems (at cost) 412 100
Retail inventory (at cost) 195 000
Prepayments 22 500
Total current assets 1 281 453
$ $
Non-current assets
Investment in debentures 100 000
Less: Unamortised debenture discount (1 713 ) 98 287
Patent rights 200 000
Less: Accumulated amortisation (30 000 ) 170 000
Land (at independent valuation 20X5) 1 200 000
Factory buildings (at independent valuation 20X5) 1 800 000
Less: Accumulated depreciation (200 000 ) 1 600 000
Factory plant and equipment (at cost) 865 400
Less: Accumulated depreciation (328 000 ) 537 400
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Fixtures and fittings—retail outlets (at cost) 68 300

Total non-current assets 3 700 287
Total assets 4 981 740
Current liabilities
Trade payables 340 000
Accruals 124 000
Provision for employee benefits 84 500
Provisions for warranties 10 500
Final dividend payable 60 000
Current tax payable 120 000
Bank loan—secured 100 000
Total current liabilities 839 000
Non-current liabilities
Provisions for warranties 35 000
Bank loan—secured‡ 900 000
Promissory notes§ 300 000
Preference shares|| 100 000
Total non-current liabilities 1 549 500
Total liabilities 2 388 500
Net assets 2 593 240
Shareholders’ equity
Share capital|| 1 050 000
Revaluation surplus# 700 000
Retained earnings 843 240
Total shareholders’ equity 2 593 240
†
Webprod Ltd has access to a bank overdraft of $200 000, which is secured by a first mortgage over
Webprod Ltd’s land and buildings. The interest rate on the overdraft is 8 per cent.
‡
The bank loan commenced on 4 November 20X5 and is for a period of 10 years at an effective interest
rate of 7 per cent. The bank loan is secured by a first mortgage over Webprod Ltd’s land and buildings.
§
The promissory notes are backed by a bank standby facility of $200 000. The facility bears interest at
9 per cent.

||
There are 50 000 redeemable fully paid preference shares that have been classified as debt. There are
1 500 000 fully paid ordinary shares. Both classes of shares have no par value.
#
The $700 000 revaluation surplus comprises $400 000 revaluation surplus in relation to land and
$300 000 revaluation surplus in relation to buildings.
Section 2: Information relating to the

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

• at cost, $213 598
• Allowance for inventory write-down, $24 921
2.2 Manufacturing inventory

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

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

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

During the financial year ending on 30 June 20X7, $9 527 330 of work in process was transferred
from work in process to finished goods. The cost of manufacturing inventory sold totalled
$9 501 630. The cost of finished goods on hand at 30 June amounted to $437 800.
Section 3: Non-current assets

Note: The carrying amount of each non-current asset is included in Section 1.
3.1 Acquisitions and disposals

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

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

Webprod Ltd adopts a policy of revaluing both its land and factory buildings annually to fair
value, in accordance with the revaluation model under IAS 16. The $700 000 revaluation surplus
(IAS 16, para. 39) as at 30 June 20X6 comprises a $400 000 revaluation increase in relation to land
and a $300 000 revaluation increase in relation to buildings.
I. Virgo, an independent valuer, carried out the revaluation as at 30 June 20X7 on the basis
of the fair value of the land and buildings from their existing use (being the highest and best
use under IFRS 13 Fair Value Measurement). Virgo determined that the value of the land and
buildings was as follows:
$
Land 970 000
Buildings 1 650 000
The buildings had been depreciated by $100 000 during the 20X7 financial year and, hence,
had an accumulated depreciation of $300 000 as at 30 June 20X7.
The revaluation of the buildings at 30 June 20X7 resulted in an increase of the buildings by
$150 000 (i.e. $1 650 000 (i.e. the fair value of the buildings as at 30 June 20X7); $1 500 000
(i.e. the value of the buildings of $1 800 000 – $300 000 accumulated depreciation of the
buildings as at 30 June 20X7).
The revaluation of the land resulted in a decrease of the land by $230 000 (i.e. $1 200 000 –
$970 000) as at 30 June 20X7. This required a reversal of the previous revaluation increase of land
recognised in the revaluation surplus of land (i.e. reduces the balance in the revaluation surplus
of land from $400 000 as at 30 June 20X6 by $230 000, as per IAS 16, para. 40, giving rise to a
balance in the revaluation surplus of land as at 30 June 20X7 of $170 000.
Therefore, the revaluation of land and buildings at 30 June 20X7 resulted in a net revaluation
decrease during the year of $80 000 (i.e. buildings increased by $150 000 and land decreased by
$230 000). For the purposes of this module, ignore any tax effects of revaluations as this topic is
not dealt with until Module 4. Therefore, assume the $80 000 is net of tax.
MODULE 2
Section 4: Wages and salaries
The following information is relevant in preparing the 20X7 accounts of Webprod Ltd:
• During the 20X7 financial year, the total payments for wages and salaries, including annual
leave, totalled $3 250 000. Long service leave paid during the same period amounted to
$22 000. Therefore, total employee benefits paid were $3 272 000.
• Employee benefits to the value of $665 281 were allocated to overhead.
Section 5: Borrowing costs

The following information is relevant in relation to borrowing costs incurred by Webprod Ltd
during 20X7:
• On 2 February 20X7, Webprod Ltd decided to construct a major item of manufacturing plant.
By 30 June 20X7, Webprod Ltd had incurred $820 000 of expenditure on the manufacturing
plant and owed creditors $30 000 for materials used in the construction process. These amounts
are included in Section 3.1 and include capitalised borrowing costs paid of $10 146.
• During 20X7, Webprod Ltd also incurred borrowing costs of $103 654, all of which have been
paid. An additional $4550 was prepaid (i.e. prepaid borrowing costs).
Section 6: Change in accounting policy

In previous financial reporting periods, Webprod Ltd expensed all borrowing costs when
incurred. Assume that during the 20X7 reporting period, IAS 23 Borrowing Costs was re-issued.
As a result, Webprod Ltd changed its accounting policy on the treatment of borrowing costs
so that borrowing costs relating to qualifying assets are now capitalised. The accounting policy
change has been made in accordance with the transitional provisions of IAS 23.
For the purposes of the case study, assume that the transitional provisions require all borrowing
costs relating to qualifying assets incurred after the date the standard is applied to be capitalised
with no adjustments to the opening balances of the financial statements.
Section 7: Revenue
7.1 Revenue recognition policy
Webprod Ltd has adopted the requirements of IFRS 15 Revenue from Contracts with Customers
as its accounting policy for the recognition of revenue.
7.2 Research and advisory services

The principals of Webprod Ltd and several key employees had considerable knowledge and
understanding of the history of the development of telecommunications in Australia. Therefore,
the company was successful in securing a contract to provide research and advisory services.
MODULE 2
Revenue from these services is recorded as ‘telecommunications project revenue’. Although the
money has not yet been received, $600 000 of revenue has been recognised during the 20X7
financial year.
7.3 Grants
On 1 January 20X7, Webprod Ltd won a $1 million AusIndustry R&D Start Grant for a computer
software project. The revenue from the grant has been recognised, but $250 000 of the grant has
not yet been received.
Section 8: 30 June 20X7 trial balance

The following is a trial balance for Webprod Ltd as at 30 June 20X7 and incorporates all
information necessary to prepare the financial report.
Dr Cr
$ $
Sales 19 194 434
Cost of sales 12 046 232
Telecommunications project revenue 600 000
Grant revenue 1 000 000
Profit on sale of factory plant 25 000
Loss on write-down of inventory 24 921
Under-applied overhead expense 87 500
Employee benefits—retail 166 320
Doubtful debts expense 5 400
Amortisation expense—patent 85 000
Depreciation expense—retail fixture and fittings 10 254
Borrowing costs expense 103 654
Damages expense 620 000
Warranties expense 12 300
Advertising campaign—new product 380 000
Audit fees 25 000
Consulting services—auditor 30 000
Selling expenses 2 415 000
Administrative expenses 3 530 077
Tax expense 387 018
Interim dividend 200 000
Final dividend 250 000
Dr Cr
$ $
Current assets
Cash at bank 192 173
Less: Allowance for doubtful debts 17 200
Grant receivable 250 000
Raw materials—at cost 53 820
Work in process—at cost 132 540
Finished goods—manufactured modems—at cost 437 800
Retail inventory—at cost 213 598
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Allowance for inventory write-down 24 921
Prepaid borrowing costs 4 550
Prepayments 58 800
Non-current assets
Unamortised debenture discount 897
Product development costs (R&D) 380 000
Patent rights 200 000
Less: Accumulated amortisation 115 000
Land (at independent valuation 20X7) 970 000
Factory buildings (at independent valuation 20X7) 1 650 000
Less: Accumulated depreciation 0
Factory plant and equipment (at cost) 1 790 246
Less: Accumulated depreciation 352 862
Current liabilities
Accruals 163 000
Provision for warranties 11 000
Provision for damages 620 000
Promissory notes 235 000
Loan—Finance Ltd 400 000
Preference shares 100 000
Share capital 1 050 000
Revaluation surplus 620 000
27 689 713 27 689 713
Notes to trial balance:

1. On average, there is a $20 000 write-down of inventory for the annual reporting period.
2. Overhead has been under-applied in the last two reporting periods by an average of $100 000
per reporting period.
3. Share capital relates to the ordinary shares. The preference shares are classified as debt.
4. No executive of Webprod Ltd earns more than $100 000.
5. A tax rate of 30 per cent applies. Tax effect accounting has not been applied.
6. The final dividend was declared prior to the end of the reporting period and does not require
shareholder approval.
7. The product development expense (non-current asset) has met the conditions of para. 57 of IAS 38
Intangible Assets and is recognised as an intangible asset in the statement of financial position.
8. On 15 January 20X7, Webprod Ltd was sued for infringement of a patent right. On 20 August 20X7,
Webprod Ltd settled the lawsuit for $620 000. A liability for damages has been recognised in the
MODULE 2
Assumed knowledge review | 159
Assumed knowledge
review
Assumed knowledge review
MODULE 2
Assumed knowledge review questions
This assumed knowledge review is designed to test your understanding of concepts that are
fundamental to this module. Answers to the questions are included at the end of the review.
If you experience difficulties with the questions in this review, consult the latest edition of
an appropriate financial accounting textbook.
Question 1
Explain how to classify the following cash flows:
(a) interest paid and interest received
(b) income taxes paid.
The following information relates to questions 2–5. These questions review how to prepare a
statement of cash flows for a non-trading entity. Their purpose is to help you judge the extent to
which you should consult an appropriate financial accounting text prior to commencing Part E
of the Module 2 study guide. The examples and questions in Module 2 are more complex and
require a basic familiarity with preparing a statement of cash flows for a trading enterprise. If you
believe it would be advantageous to review your understanding of statements of cash flows in the
context of a trading entity, you should consult the latest edition of an appropriate text such as:
• Henderson, S. & Peirson, G. et al. 2013, Issues in Financial Accounting, Pearson, Melbourne
• Hoggett, J. R. & Edwards, L. et al. 2014, Financial Accounting, John Wiley & Sons, Brisbane.
Before considering the questions, read paras 18–20 of IAS 7 Statement of Cash Flows. Please note
that this material adopts the following disclosure approach:
• On the statement of cash flows, cash flows from operating activities will be reported using
the direct method (gross cash inflows and gross cash outflows from operating, investing and
financing activities).
• The notes to the financial statements contain disclosure of the indirect method with a
reconciliation between profit for the year and cash flow from operating activities.
This approach is consistent with IAS 7, which encourages the use of the direct method (para. 19).
The following information relates to the activities of Management Services Ltd. (Note that it is
an abbreviated version of the requirements of IAS 1.)
Statement of profit or loss and other comprehensive income of Management Services Ltd
for the year ended 30 June 20X3
$ $
Revenues 500 000
Less: Expenses (excluding depreciation) 277 000
Depreciation expense 23 000 (300 000 )
Net profit before income tax 200 000
Less: Income tax expense (60 000 )
Net profit after income tax 140 000
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Statement of financial position of Management Services Ltd at 30 June 20X3
20X2 20X3 Change

$ $ $
Cash at bank 49 000 37 000 (12 000 )
Trade receivables 37 000 30 000 (7 000 )
Prepaid expenses 5 000 6 000 1 000
Land and buildings 34 000 250 000 216 000
Less: Accumulated depreciation (10 000 ) (33 000 ) (23 000 )
Total assets 115 000 290 000
Trade payables and accruals 6 000 40 000 34 000

Current tax payable 14 000 60 000 46 000
Debentures 15 000 — (15 000 )
Share capital 40 000 40 000 —
Retained earnings 40 000 150 000 110 000
Net assets 115 000 290 000
Question 2
Direct method of calculating and reporting cash flows from operating activities
Using the information provided for Management Services Ltd, calculate the net cash flows from
operating activities by adjusting the P&L and OCI items for changes in assets and liabilities that
affected the determination of profit (e.g. receivables, payables). This is the second of the two
techniques referred to in para. 19 of IAS 7.
The general principle that underlies the calculations is as follows. The gross cash inflow or
outflow relating to an item of revenue or expense is found by adjusting the dollar amount of
items appearing in the P&L and OCI (excluding non-cash items, such as depreciation) by the
change(s) in the related statement of financial position item(s). The gross cash inflow or outflow
may be found by direct adjustment or by reconstruction of the related ledger accounts.
Question 3
Indirect method of calculating and reporting cash flows from operating activities
Using the information provided for Management Services Ltd, reconcile the net cash provided by
operating activities to the net profit for the year. Provide brief reasons for each adjustment made
to the profit for the year. Comparative figures are not required.
Question 4
Cash flows from investing activities and cash flows from financing activities
Using the information provided for Management Services Ltd, calculate the cash flows from
investing activities and the cash flows from financing activities.
Question 5
Statement of cash flows
Using the information provided for Management Services Ltd, prepare a statement of cash flows
using the direct method in the form set out in the illustrative examples of IAS 7.
MODULE 2
Assumed knowledge review answers
Question 1
In both cases (a) and (b), the cash flow could be classified in more than one way.
(a) Interest paid and interest received

Interest paid (borrowing costs paid) is typically regarded as an operating cash outflow as
per para. 33 of IAS 7. In the illustrative example shown in Appendix A of IAS 7, interest paid
is classified as an operating cash outflow. However, the same paragraph goes on to state
that an entity may elect to show interest paid as a cash outflow from financing activities.
The rationale behind this is that interest represents a cost of obtaining financial resources.
Interest received is typically regarded as an investing cash inflow as per para. 31 of IAS 7.
In the illustrative example shown in Appendix A of the standard, interest received is classified
as an investing cash inflow. However, the same paragraph goes on to state that an entity
may elect to show interest received as a cash inflow from operating activities because they
represent returns on investments.
This module uses the same approach as the illustrative examples in IAS 7.
(b) Income taxes paid

Because income tax is included as an expense in determining profit after tax, it is normally
classified as an operating cash outflow (IAS 7, para. 14) unless the cash flow can be identified
with particular investing or financing activities.
Question 2
Net cash flows from operating activities of Management Services Ltd for the year
ended 30 June 20X3
Based on the data provided, net cash flows from operations would be reported using the direct
method, as follows:
$
Payments to employees and suppliers (including prepaid expenses) (244 000 )
Income tax paid (14 000 )
Net cash flows from operating activities 249 000
These amounts have been calculated as described in the following.

Receipts from customers

To determine the amount of receipts from customers, the following calculation is necessary:
Receipts from customers: $

Opening balance of trade receivables 37 000
Plus: Sales revenue 500 000
537 000
Less: Closing balance of trade receivables (30 000 )
Payments to suppliers and employees

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To determine the amount of payments to suppliers and employees, the following reconstruction
is necessary:
Payments to supplier and employees: $

Opening balance of trade payables and accruals 6000
Plus: Expenses (excluding depreciation) 277 000
Plus: Increase in prepaid expenses 1 000
284 000
Less: Closing balance of trade payables and accruals (40 000 )
Payments to suppliers and employees 244 000
If Management Services Ltd had held inventories, the opening and closing balances of inventories
would need to be taken into account in determining the amount of inventory purchased on credit.
This figure would flow through the above calculation. However, this is not relevant in the current
situation as Management Services Ltd does not have any inventory on hand.
Income taxes paid:

IAS 7 requires separate disclosure of income taxes paid in the statement of cash flows. Income
taxes paid forms part of the cash flows from operating activities. The amount of tax paid in the
current financial year largely depends on whether there are temporary differences (i.e. deferred
tax assets (DTA) or deferred tax liabilities (DTL)).
There are not to be any DTAs or DTLs in the statement of financial position. The amount of
income tax paid in the current year will simply be the opening balance of current tax payable
at 30 June 20X2. This figure is $14 000. This amount is disclosed in the statement of cash flows.
The amount of income tax expense in the current year (i.e. $60 000) is reflected in the current tax
payable liability account in the statement of financial position and will be paid to the taxation
authorities in the following financial year. That will form part of the following year’s statement of
cash flows.
An alternative to the above calculations would be to reconstruct the ledger accounts involved.
If you are unsure of the above answers, please reconstruct the relevant ledger accounts now.
Question 3
When the indirect method is used, the starting point is the net profit or loss for the period.
This result is reconciled to net cash flows from operating activities by first adjusting the former
for income and expense items that were not the result of operating cash transactions during the
reporting period. Such adjustments may arise from two sources:
1. non-cash income and expense items such as depreciation and profits and losses on the sale
of plant and equipment
2. changes in statement of financial position items that affected the determination of profit,
such as net changes in trade receivables, trade payables and inventories (i.e. movements in
opening and closing balances of current assets and current liabilities).
Another adjustment that may be relevant to some entities is where an item is included in the profit
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or loss but the related cash flow is classified as an investing or financing activity. For example,
some entities may treat dividends received as a cash flow from investing activities.
Reconciliation of profit or loss to net cash from operating activities for the period
$
Net profit for the period 140 000
Non-cash adjustments
Add: Depreciation expense1 23 000
Add/Less:
Decrease in trade receivables2 7 000
Increase in prepaid expenses3 (1 000 )
Increase in trade payables and accruals4 34 000
Increase in current income tax payable5 46 000
Net cash from operating activities 249 000
Notes on adjustments:
1. Depreciation expense is added back because the expense is a non-cash item; it does not reflect an
outlay of cash made in the current period.
2. A decrease in trade receivables implies that the amount of cash collected from customers in the current
reporting period exceeds the sum of credit and cash sales revenue recognised in that period. The lesser
amount (sales revenue) has been credited to the P&L and OCI in measuring profit. The extra cash
collected is allowed for by adding back to profit or loss the decrease in trade receivables.
3. An increase in prepaid expenses implies that the amount of cash disbursed for prepayments exceeds
the amount of prepayments charged as expense (expired prepayments). The lesser amount, expired
prepayments, has been deducted in the P&L and OCI in determining current period profit or loss.
The larger cash outlay is allowed for by deducting the increase in prepaid expenses from profit or loss.
4. An increase in trade payables and accruals implies that cash outlays for expenses are less than expenses.
The larger amount expenses, has been deducted in arriving at the profit in the P&L and OCI, the lesser
cash outlay is arrived at by adding back to the profit or loss the increase in trade payables.
5. An increase in current income tax payable implies that the cash outflow for tax in the current period
is less than the tax expense of that period. (In the absence of deferred tax accounts, the amount by
which the expense exceeds the cash flow is equal to the increase in the current tax payable account.)
The larger amount, tax expense, has been deducted in arriving at the profit in the P&L and OCI.
The lesser cash outlay is arrived at by adding back to profit or loss the increase in current tax payable.
6. Another way to simplify the adjustments is to note the following rule:

– Any credit movements (i.e. where current assets decrease or where current liabilities increase)
result in an addition in the reconciliation.
– Any debit movements (i.e. where current assets increase or where current liabilities decrease)
result in a subtraction in the reconciliation.
In other words:

Decrease in asset Add
Increase in asset Less
Decrease in liability Less
Increase in liability Add
Question 4
Cash flows from investing activities
MODULE 2
Investing activities relate to the purchase and sale of non-current assets during the reporting
period. Most investing cash inflows and outflows will come from analysing the movements in the
non-current assets accounts in the statement of financial position.
An inspection of the statement of financial position of Management Services Ltd reveals that land
and buildings have increased by $216 000 (from $34 000 to $250 000).
It is possible that these land and buildings were revalued. However, there is no corresponding
asset revaluation (revaluation surplus) account shown in equity. Hence, it can be concluded that
the entity acquired land and buildings during the financial year totalling $216 000. The cash
outflow from investing activities is therefore $216 000.
Cash flows from financing activities

Financing cash flows relate to changes in the financing activities of the entity (i.e. movements in
debt and equity). Cash flows from financing activities typically include proceeds from borrowings,
repayment of borrowings and the proceeds from the issue of shares.
An inspection of the statement of financial position of Management Services Ltd reveals that
share capital has not increased or decreased during 20X3. Hence, the company did not issue any
shares or redeem (or buy back) any of its share capital during the financial year.
However, the amount of debentures (a form of long-term liability) decreased from $15 000 to $Nil
during 20X3. This means that the company redeemed its debentures, resulting in a cash outflow
of $15 000.
The cash flows from the financing section of the statement of cash flows also record the amount
of dividends paid by the entity during the reporting period. The company’s net profit after tax
(as per the P&L and OCI) was $140 000. This flows through into the retained earnings section
in the statement of financial position. However, the increase in the retained earnings balance
between 20X2 and 20X3 was only $110 000. This means that the amount of dividends paid during
the 20X3 financial year totalled $30 000. Put another way:
Dividends paid = Net profit after tax − Increase in retained earnings

= $140 000 − $110 000
= $30 000
Alternatively, Dividends paid = Opening balance of Retained Earnings +

Net profit after tax for the current period –
Ending balance of retained earnings
= $40 000 + 140 000 – 150 000
= $30 000
The net cash flows used in financing activities were therefore $45 000.
$
Debenture repayment (15 000 )
Dividends paid (30 000 )
(45 000 )
Question 5
Management Services Ltd
Statement of cash flows for the reporting period ended 30 June 20X3
MODULE 2
Inflows Inflows
(Outflows) (Outflows)
Cash flows from operating activities
Payments to employees and suppliers (244 000 )
Income taxes paid (14 000 )
Net cash from operating activities 249 000
Payment for land and buildings (216 000 )
Repayment of debenture liability (15 000 )
Dividends paid (30 000 )
Net cash used in financing activities (45 000 )
Net decrease in cash and cash equivalents held (12 000 )
Cash and cash equivalents at the beginning of the reporting period 49 000
Cash and cash equivalents at the end of the reporting period 37 000
MODULE 2
Suggested answers
Suggested answers
MODULE 2
Question 2.1
(a) The accounting policies of Techworks Ltd comply with the requirements of IAS 1 as follows:
–– the accounting policies present information about the preparation of the financial
statements and the specific accounting policies adopted in the notes to the financial
statements (para. 112(a))
–– the basis of preparation of the financial statements (prepared in accordance with
Australian Accounting Standards as issued by the Australian Accounting Standards
Board (AASB) and the International Financial Reporting Standards (IFRS) as issued by
the International Financial Accounting Standards Board (IASB) and the requirements
of the Australian Corporations Act is disclosed in the notes (para. 112(a))
–– the measurement basis (historic cost, except for derivatives and certain financial assets
measured at fair value) has been identified that was used in preparing the financial
statements (para. 117(a))
–– in accordance with para. 117(b), the summary describes accounting policies relevant for
a proper understanding of the financial statements.
(b) The notes to the financial statements of Webprod Ltd would include the following initial Note:
1. Statement of significant accounting policies
(A) Basis of preparation
The financial statements of Webprod Ltd are general purpose financial statements that
have been prepared in accordance with the IFRSs. It has been prepared on the basis of
historical cost, except for land and factory buildings, which are measured on a fair value
basis. An independent valuer determines fair value on an annual basis. The accounting
policies of Webprod Ltd are consistent with those of the previous year.

Question 2.2
(a) As detailed in Note 1(b) basis of accounting, the following Accounting Standards have been
issued by the AASB, but have not been adopted in the preparation of the 30 June 2016
financial statements:
• AASB 9 Financial Instruments (has a mandatory application date for financial years
commencing on or after 1 January 2018)
• AASB 16 Leases (has a mandatory application date for financial years commencing
on or after 1 January 2019).
(b) As detailed in Note 1(b) basis of accounting, the following Accounting Standards have
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been early adopted by Techworks Ltd:

• AASB 15 Revenue from Contracts with Customers.
The group has elected to early adopt AASB 15 Revenue from Contracts with Customers,
as issued in December 2014, which would otherwise be mandatory, effective for annual
reporting periods beginning on or after 1 January 2018. The initial application date for the
group is 1 July 2014. The group has elected to apply the standard on a full retrospective
basis as permitted by AASB 15 whereby the cumulative effect of retrospective application
is recognised at the date of initial application by adjusting opening retained profits or
other relevant components of equity. Comparatives for the 30 June 2015 year have also
been restated.
(c) The notes to the financial statements of Webprod Ltd would include the following:
1. Statement of significant accounting policies
(B) Change in accounting policy
During the 20X7 reporting period, IAS 23 Borrowing Costs was issued. As a result,
Webprod Ltd changed its accounting policy on the treatment of borrowing costs.
Previously all borrowing costs were expensed as incurred. The transitional provisions
of IAS 23 require borrowing costs that relate to qualifying assets and that are incurred
after the date the standard is applied to be capitalised. In addition, no adjustments are
to be made to the opening balances of the financial statements.
From 1 July 20X6, any borrowing costs relating to qualifying assets were capitalised
during the reporting periods in which construction of the asset took place. During the
20X7 reporting period, Webprod Ltd included $10 146 of borrowing costs as part of
factory, plant and equipment under construction. This change in accounting policy is
also expected to materially affect subsequent reporting periods.
Question 2.3
The events outlined in Note 36 of the BHP Billiton 2014 annual report relate to conditions
that arose after the end of the reporting period. The legislation to repeal the MRRT received
support of both Houses of Parliament on 2 September 2014. The event would be considered a
non‑adjusting event.

Question 2.4
The first subsequent event disclosed in Note 23 relates to the renegotiation of the loan facility
and subsequent repayments. Note 23 states:
The group renegotiated its existing loan finance facility in August 2016; the total amount available
amount under the facility was increased by $60 000 000, which is expected to be drawn down
over the next 12 months. The renegotiated facility will be repaid in three annual instalments,
commencing in August 2021.
This event meets the definition of a non-adjustable event, as it is one that arises after the
reporting date for the first time. In other words, this event did not relate to a condition that
existed at the reporting date. As such, para. 10 of IAS 10 requires that the entity shall not adjust
MODULE 2
the financial statements in respect of these events. Instead, the event should be disclosed as a
note in the financial statements (which has been done by Techworks Ltd).
The second subsequent event is the declaration of a final dividend by the directors on
17 October 2016.
Refer to note for the final dividend recommended by directors, to be paid on 17 October 2016.
Once again, the declaration (and payment) of a dividend after 30 June 2016 meets the definition
of a non-adjustable event. As such, the financial statements do not need to be adjusted.
However, note disclosure needs to be made (as is the case).
Furthermore, para. 13 of IAS 10 confirms that if an entity declares a dividend after the reporting
period but before the financial statements are authorised for issue, the dividends are not
recognised as a liability at the end of the reporting period because no obligation exists at
that time. As such, the dividends should be disclosed in the notes to the accounts.
Question 2.5
(a) A major drop in the share price on 30 July is considered a non-adjusting event, as it relates
to an event that does not reflect conditions existing at the end of the reporting period.
The information relevant at 30 June is the market price of the shares at that date, which was
correct at that time. The drop in share prices occurred after 30 June as a result of new
information subsequent to reporting date. Therefore, the investments will not be adjusted
in the statement of financial position, but the nature of the event and its financial effect
should be disclosed in the notes to the financial statements (IAS 10, para. 8).
(b) A debtor who owed a significant sum of money at 30 June and is declared bankrupt on
18 August is likely to be an adjusting event. If the debtor’s account was significantly overdue
at 30 June, the bankruptcy is probably just a confirmation that the debtor could not pay at
reporting date. Here, the event of bankruptcy simply confirms conditions at the end of the
reporting period. Therefore, the accounts receivable in the statement of financial position
would be adjusted accordingly (IAS 10, para. 8).
On the other hand, if the debtor experienced financial problems after 30 June—for example,
where a fire destroyed the debtor’s business in early July, causing extreme financial difficulties—
then it could be argued that the financial statements should not be adjusted. Instead, details of
the bankruptcy should be disclosed in the notes as this would constitute a non-adjusting event
(IAS 10, para. 21).
It is important to note that all circumstances must be taken into account, and professional
judgment is often required when dealing with events after the end of the reporting period.
(c) A major explosion on 20 July is a non-adjusting event as it relates to an event that does
not reflect conditions existing at the end of the reporting period. It should not result in
adjustments of assets and liabilities, but details of the nature and financial effect of the
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event should be disclosed (IAS 10, para. 21).
Question 2.6
Note: IAS 1 paragraph numbers are provided for your reference.
Statement of profit or loss and other comprehensive income of Webprod Ltd for the
year ended 30 June 20X7
$ IAS 1
Revenue 20 794 434 82(a)
†
Interest revenue accounted for using

the effective interest method 12 283
Other income 25 000 ‡
Expenses excluding finance costs (19 438 004 )§
Operating profit 1 393 713

Finance costs (103 654 ) 82(b)
Profit before tax 1 290 059
Income tax expense (387 018 )|| 82(d)
Profit for the year 903 041 81A(a)
Items that will not be reclassified to profit or loss
Other comprehensive income (net of tax):
Revaluation surplus 82A
Revaluation surplus—land (230 000 )
Revaluation surplus—buildings 150 000
Other comprehensive income for the year, net of tax (80 000 )# 81A(b)
Total comprehensive income for the year 823 041 81A(c)
Note: Allocations between non-controlling interests and parent entity owners will not be dealt
with until Module 5 and have not been incorporated into the ‘Case study data’.
Calculations
†
Calculation of revenue $
Sales 19 194 434

Telecommunications project revenue 600 000
20 794 434
‡
Other income
§
Calculation of expenses excluding finance costs $
Cost of sales 12 046 232
Loss on write-down of inventory 24 921
MODULE 2
Employee benefits expense retail 166 320
Doubtful debts expense 5 400
Amortisation expense 85 000
Warranty expense 12 300
Audit fees 25 000
Consulting fees—auditor 30 000
Advertising campaign—new product 380 000
Selling and marketing expenses 2 415 000
Other administrative expenses 3 530 077
19 438 004

||
1 290 059 × 0.30 = $387 018
#
Balance as at
Revaluation surplus 20X6 20X7 30 June 20X7
Land 400 000 (230 000 ) 170 000
Buildings 300 000 150 000 450 000
Total 700 000 (80 000 ) 620 000
Note: According to IAS 16 (para. 40), the revaluation decrease of land is recognised in P&L only if there
is no existing credit balance in the revaluation surplus in respect of that asset. If there is an existing credit
balance, the decrease will be first adjusted to the extent of the credit balance existing in the revaluation
surplus account. If the revaluation decrease exceeds the credit balance in the revaluation surplus account,
the excess is recognised in P&L. As per Section 3.3 of the Case data, the 20X6 credit balance of the
revaluation surplus of the land was $400 000, hence, the entire revaluation decrease of $230 000 will be
adjusted to the revaluation surplus of the land, and recognised in the OCI.
According to IAS 36 (para. 39), the revaluation increase of buildings is to be recognised in OCI under
‘Revaluation surplus—buildings’ in the P&L and OCI.
For the purposes of this module, ignore any tax effects of revaluations as this topic is not dealt with until
Module 4. Therefore, assume the $80 000 is net of tax.

Question 2.7
(a) As outlined in para. 96 of IAS 1, reclassification adjustments do not arise on changes in
revaluation surplus made in accordance with either IAS 16 Property, Plant and Equipment
or IAS 38 Intangible Assets. While such items are included in OCI, they are not reclassified
into the P&L in subsequent periods. Changes in revaluation surplus may be transferred to
retained earnings in subsequent periods as the asset is used or when it is derecognised.
(b) The disposal of the foreign operation would require the following items to be recognised in
the determination of profit or loss and other comprehensive income for the reporting period
during which the disposal took place.
MODULE 2
Profit or loss $
Exchange difference on translating foreign operation 10 000
Income tax expense 3 000
Net exchange difference recognised in profit or loss 7 000
Other comprehensive income $

Exchange difference on translating foreign operation (net of tax)† 2 800
Reclassification adjustment (net of tax)‡ (7 000 )
Net exchange difference recognised in other comprehensive income (4 200 )
†
Of the accumulated exchange difference gains of $7000, $2800 (pre-tax of $4000) relates to the
current period. The exchange difference arising up to the date of disposal of the foreign operation
is initially included in other comprehensive income.
‡
The reclassification adjustment is for the accumulated exchange difference gains (net of tax) over
the total period that the foreign operation was in existence. As the foreign operation has been
disposed of, this exchange difference gain can now be recognised in profit or loss.
The impact on total comprehensive income for the current reporting period is net of tax
$2800. The disposal of the foreign operation gives rise to the realisation of an accumulated
exchange difference gain (net of tax) of $7000. Due to it being realised, it is to be recognised
in profit or loss. Prior to the disposal, however, the exchange difference gain in the current
period was unrealised and, as a result, was recognised in OCI. The unrealised exchange
difference gain was spread over several reporting periods, with $2800 being recognised in the
current reporting period in OCI (prior to it being realised) and the remaining $4200 recognised
in OCI of prior periods. Due to the reclassification of the exchange difference gain from OCI
(when it was unrealised) to profit or loss (upon becoming realised) a reclassification adjustment
net of tax of $7000 is recognised in OCI. This occurs in the current reporting period when the
realisation occurs. As the exchange difference gain of $2800 remains recognised in OCI in
the current reporting period, the net exchange difference recognised in OCI in the current
reporting period is ($4200) (being $2800 – $7000). This amount offsets the exchange difference
gain recognised in OCI of prior periods, so that the total impact of the foreign operation on
OCI is $nil.
The following table illustrates what has been recognised in the P&L and OCI of the reporting
entity over the life of the foreign operation.
Prior Current Total impact
periods period over life
($) ($) ($)
Profit or loss (after tax) — 7 000 7 000
Other comprehensive income
Exchange difference on translating
foreign operation 4 200 2 800
Less: Reclassification adjustment (7 000 )
Other comprehensive income 4 200 (4 200 ) —
Total comprehensive income 4 200 2 800 7 000
MODULE 2
Question 2.8
(a) Paragraph 97 of IAS 1 indicates that when an item of income or expense is material, its nature
and amount must be separately disclosed. That is, it is a material item because it could
influence the decision-making of financial statement users. This depends on the size and
nature of the item in the context of circumstances involved.

The determination of such items is a matter of judgment. In the case of Webprod Ltd,
the items that shall be considered for separate disclosure are interest revenue calculated
using the effective interest method, the loss on write-down of inventory expense,
the damages expense and the advertising campaign for new product. The nature and
size of these items would be relevant to users’ understanding of the financial performance
of Webprod Ltd. These items can be disclosed separately in the P&L and OCI or in the notes
to the financial statements.
Note that it is acceptable you to have included other items based on your interpretation
of the information provided.
(b)
Webprod Ltd
Statement of profit or loss and other comprehensive income
for the year ended 30 June 20X7
Note $ Para./Std
Revenue 1 20 794 434 B87– 89/IFRS 15
Interest revenue using the effective interest method 12 283 82(a)/IAS 1
Cost of sales 5, 7 (12 046 232 ) 99/IAS 1
Gross profit 8 760 485 85/IAS 1
Other income 1 25 000
8 785 485
MODULE 2
Expenses
Retailing expenses 2, 5, 7 (2 971 574 )(a) 99/IAS 1
Product expenses 3, 4, 5 (829 721 )(b) 99/IAS 1
Administrative expenses 7 (3 585 077 ) (c)
99/IAS 1
Other expenses 6 (5 400 )(d)
Finance expenses (103 654 ) 82(b)/IAS 1
Profit before income tax 1 290 059
Income tax expense (387 018 ) 82(d)/IAS 1
Profit for the year 903 041 81A(a)/IAS 1
Other comprehensive income (net of tax):
Revaluation Surplus 82A/IAS 1
Revaluation surplus—land (230 000 )
Revaluation surplus—buildings 150 000
Other comprehensive income for the year, net of tax (80 000 ) 81A(b)/IAS 1
Total comprehensive income for the year 823 041 81A(c)/IAS 1
Notes to the financial report

The following disclosure notes may include additional information regarding the nature of the
item that was not provided in the case study information. You are not expected to know this
information—it has been included for illustrative purposes only.
Note 1: Revenues and other income

(a) Revenue $ Para./Std
Sales revenue 19 194 434 B87–89/IFRS 15
Telecommunications project service revenue 600 000 B87–89/IFRS 15
20 794 434
(b) Other income
Note 2: Advertising campaign—new product 97/IAS 1

Included in the retail expenses is $380 000 paid for an advertising campaign to launch
Webprod Ltd’s new high-speed modem.
Note 3: Write-down of inventory 97/IAS 1

Because of rapid changes in the computer industry, two lines of software and one line of
hardware will have to be sold at substantial discounts. As a result, these inventory items have
to be carried at net realisable value at 30 June. This has resulted in an inventory write-down
of $24 921.

Note 4: Damages—lawsuit 97/IAS 1

On 15 January 20X7, Webprod Ltd was sued for infringement of a patent right.
On 20 August 20X7, Webprod Ltd settled the lawsuit for $620 000. A liability for damages
has been recognised in the statement of financial position.
Note 5: Depreciation and amortisation 104/IAS 1

Amortisation of patent rights 85 000
Depreciation of non-current assets 232 116 †

†
Depreciation of retail fixtures and fittings $10 254 + Depreciation of factory and plant $221 862
(see Section 3.2 of ‘Case study data’).
Note 6: Bad and doubtful debts
MODULE 2
During the 20X7 financial year, Webprod Ltd incurred a doubtful debt expense of $5400.
Note 7: Employee benefits 104/IAS 1

During the 20X7 financial year, Webprod Ltd incurred employee benefit expenses
of $3 272 000 (see Section 4 of ‘Case study data’).
Calculations $
(a) Retailing expenses
Employee benefits—retail 166 320
Depreciation expense—retail fixtures and fittings 10 254
Advertising campaign new product 380 000
Other selling expenses 2 415 000
2 971 574
(b) Product expenses $

Write-down of inventory 24 921
Under-applied overhead 87 500
Amortisation of patent rights 85 000
Warranty expense 12 300
829 721
(c) Administrative expenses

Audit fees 25 000
Consulting services—auditor 30 000
Other administrative expenses 3 530 077
3 585 077
(d) Other expenses (from ordinary activities)

Doubtful debts 5 400

Question 2.9
Webprod Ltd
Statement of changes in equity for the year ended 30 June 20X7
Share Revaluation Retained

capital ($) surplus ($) earnings ($) Total ($) IAS 1
Balance 1 July 20X6
†
1 050 000 700 000 843 240 2 593 240 106(d)
Comprehensive income‡ (80 000 ) 903 041 823 041 106(a)
Dividends paid or declared§ (450 000 ) (450 000 ) 106(d)(iii)
Balance 1 July 20X7 1 050 000 620 000 1 296 281 2 966 281 106(d)
MODULE 2
†
See Case study data Section 1 for the closing balance of shareholders’ equity for the prior reporting
period (i.e. the opening balance as at 1 July 20X6).
Shareholders’ equity As at 30 June 20X6

Share capital 1 050 000

‡
Comprehensive income for 20X7 (see the Suggested answer to Question 2.6).
Comprehensive income items for the year ended 30 June 20X7

Profit for the year 903 041
Other comprehensive income (net of tax) (80 000 )
Total comprehensive income 823 041
§
Dividends paid or declared (see Case study data Section 8).
Dividends paid or declared for the year ended 30 June 2017

Interim dividend 200 000
Final dividend 250 000
Total dividends paid or declared 450 000
Dividend per share $0.30 ($450 000/number of ordinary shares,
being 1 500 000 as per Case data Section 1)

Question 2.10
Statement of financial position for Webprod Ltd as at 30 June 20X7
Note $ IAS 1
Current assets
Cash and cash equivalents 1 192 173 54(i)
Trade and other receivables 2 984 010 54(h)
Inventories 3 812 837 54(g)
Other current assets 4 63 350
Total current assets 2 052 370
MODULE 2
Non-current assets
Trade and other receivables 2 50 000 54(h)
Financial assets 5 99 103 54(d)
Property, plant and equipment 6 4 099 730 54(a)
Intangible assets 7 465 000 54(c)
Total non-current assets 4 713 833
Total assets
6 766 203
Current liabilities
Trade and other payables 8 505 500 54(k)
Current tax payable 387 018 54(n)
Borrowings 9 100 000 54(m)
Provisions 10 741 000 54(l)
Total current liabilities 1 983 518
Borrowings 9 1 535 000 54(m)
Provisions 10 281 404 54(l)
Total non-current liabilities 1 816 404
Total liabilities
3 799 922
Net assets
2 966 281
Issued capital 11 1 050 000 54(r)
Reserves 12 620 000 54(r)
Retained earnings 1 296 281 54(r)
Note: As explained in the module notes, para. 77 requires further subclassification of the line
items, presented in a manner appropriate to the entity’s operations.
The following subclassifications illustrate the composition of the items in the statement
of financial position.
Extracts from notes to accounts

1. Cash and cash equivalent $
Cash at bank and on hand 192 173
2. Trade and other receivables $

Current
Less: Allowance for doubtful debts (17 200 )
706 010
MODULE 2
Grant receivable 250 000

984 010
Non-current
3. Inventories $
Raw materials—at cost 53 820
Work in process—at cost 132 540
Manufactured finished goods—at cost 437 800
Retail inventory—at cost 213 598
Less: Allowance for inventory write-drown (24 921 )
812 837
4. Other current assets $

Prepaid borrowing costs 4 550
Other prepayments 58 800
63 350
5. Financial assets $
Unamortised debenture discount (897 )
99 103
6. Property, plant and equipment

Land and buildings $
Land—independent valuation 20X7 970 000
Factory buildings—independent valuation 20X7 1 650 000
2 620 000
Factory plant and equipment (at cost) 1 790 246

Accumulated depreciation (352 862 )
1 437 384

Accumulated depreciation (33 954 )
42 346
Total property, plant and equipment 4 099 730
Webprod Ltd adopted a policy of revaluing both its land and factory buildings annually to fair
value, in accordance with the revaluation model under IAS 16.
I. Virgo, FAIV, an independent valuer, carried out the revaluation as at 30 June 20X7 on the basis
of the fair value of the land and buildings from their existing use (being the highest and best
use under IFRS 13 Fair Value Measurement). Virgo determined that the value of the land and
buildings was as follows:
$
Land 970 000
Buildings 1 650 000
7. Intangibles $
Patent rights (at cost) 200 000
Accumulated amortisation (115 000 )
85 000
MODULE 2
Product development costs (R&D) 380 000
465 000
8. Trade and other payables $

Accruals 163 000
505 500
9. Borrowings
Current $
Non-current
Promissory notes 235 000
Loan—Finance Ltd 400 000
Preference shares 100 000
1 535 000
10. Provisions
Current $
Employee benefits 110 000
Warranties 11 000
Damages—lawsuit 620 000
741 000
Non-current
Employee benefits 243 404
Warranties 38 000
281 404
11. Issued capital

$ IAS 1
Issued and fully paid capital
1 500 000 fully paid ordinary shares (no par value) 1 050 000 79(a)(ii)(iii)
The company had 1 500 000 ordinary shares outstanding at the beginning and end of the year
ending 30 June 20X7 (79(a)(iv))
12. Reserves
$ IAS 1
Revaluation surplus† 620 000 79(b)
†
See suggested answer to Question 2.6.

Question 2.11
1. Cash received from customers: $19 534 264
In order to determine the amount of receipts from customers, the following formula may be used:
Opening balance of + Sales revenue − Bad debts − Closing balance of

trade receivables written off † trade receivables
MODULE 2
†
To determine the amount of bad debts written off, the following formula is relevant:
Opening balance of + Doubtful debts expense − Closing balance of

allowance for doubtful debts (from P&L) allowance for doubtful debts
The amount of receipts from customers is calculated as follows:

$
Opening balance of trade receivables 467 840
Plus: Sales revenue 19 194 434
Plus: Telecommunications project revenue 600 000
20 262 274
Less: Bad debts written off (see calculation below‡) (3 800 )
20 258 474
Less: Closing balance of trade receivables (723 210 )
Receipts from customers 19 535 264
This represents a cash inflow from operating activities.
‡
Bad debts written off are determined as follows:
Opening balance of allowance for doubtful debts 15 600

Plus: Doubtful debts expense 5 400
21 000
Less: Closing balance of allowance for doubtful debts (17 200 )
Bad debts written off 3 800
2. Cash received from grants: $750 000

In order to determine the amount of grants received, the following formula may be used:
Opening balance of + Grants revenue − Closing balance of

grants receivable grants receivable
The amount of receipts from grants is calculated as follows:

$
Opening balance of grants receivable —
Plus: Grants revenue 1 000 000
1 000 000
Less: Closing balance of grants receivable (250 000 )
Grants received 750 000
This represents a cash inflow from operating activities.
3. Cash paid to suppliers: $15 216 421
MODULE 2
There are several steps in determining the amount of payment to suppliers and employees.
Step 1: Purchase of raw materials on credit

The first step involves determining the amount paid to purchase inventories—namely,
raw materials—on credit.
Section 2.2.1 of the ‘Case study data: Webprod Ltd’ indicates that the company purchased raw
materials totalling $5 423 500.
Alternatively, this amount may have been calculated using the following formula:
Closing balance of + Cost of raw materials − Opening balance of

raw materials allocated to work in progress raw materials
The amount of raw materials purchased is calculated as follows:

$
Closing balance of raw materials 53 820
Plus: Raw materials allocated to work in process (given in question) 5 432 180
5 486 000
Less: Opening balance of raw materials (62 500 )
Raw materials purchased 5 423 500
Step 2: Purchase of retail inventories on credit

The second step involves determining the amount paid to purchase inventories—namely,
retail inventories—on credit.
We are told in Section 2.1 of the case study that the company purchased retail inventories
totalling $2 563 200.
Alternatively, this amount may have been calculated with the following formula:
Closing balance of + COGS − Opening balance of

retail inventories retail inventories
The amount of retail inventories purchased is calculated as follows:

$
Closing balance of retail inventories at cost 213 598
Plus: COGS (see Section 2 note 2.1) 2 544 602
2 758 200
Less: Opening balance of retail inventories (195 000 )
Retail inventories purchased 2 563 200
Step 3: Determining the amount of cash paid to the suppliers of inventories

To determine the amount of inventories purchased for cash, it is necessary to adjust for the
opening and closing balances of trade payable. The Case study has assumed that trade payable
relates solely to the suppliers of raw materials and retail inventories.
MODULE 2
The following formula may be used:
Opening balance of + Inventories purchased on − Closing balance of

trade payable credit (from above) trade payables
The amount of cash purchases of inventories is calculated as follows:

$
Opening balance of trade payables 340 000
Plus: Inventories purchased on credit† 7 986 700
8 326 700
Less: Closing balance of trade payables (342 500 )
Cash paid to the suppliers of inventories 7 984 200
†
Inventories purchased are $7 986 700 (raw materials $5 423 500 + retail inventories $2 563 200).
Step 4: Determining the amount of operating expenses paid

The next step is to determine the amount of operating expenses paid during the current
reporting period. To do this is a two-step process.
First, exclude non-cash expenses and expenses relating to investing and financing activities
that appear in the P&L and OCI.

Non-cash expenses include:
$
Damages expense (provision) 620 000
Employee benefits—retail (provision) 166 320
Loss on inventory write-down 24 921
Warranty expense (provision) 12 300
Total non-cash expenses: 1 006 295
Borrowing costs (expenses relating to investing and financing activities) 103 654
The remaining expenses include:

$
Audit fees 25 000
Consulting fees 30 000
Advertising campaign 380 000
Selling and marketing expenses 2 415 000
Other expenses 3 530 077
Total remaining expenses: 6 380 077
Second, determine the amount of the remaining operating expenses for which cash has been
paid, given some of the operating expenses may have been incurred but have not been paid in
full. To determine the amount of operating expenses paid during the current reporting period,
MODULE 2
it is necessary to adjust for the opening and closing balances of accruals.
The following formula may be used:
Opening balance + Operating expenses − Closing balance

of accruals incurred (from above) of accruals
The amount of cash expenses is calculated as follows:

$
Opening balance of accruals 124 000
Plus: Operating expenses incurred (from above) 6 380 077
6 504 077
Less: Closing balance of accruals ($163 000 − $30 000)† (133 000 )
Operating expenses paid 6 371 077
†
We are told in the question that during the 20X7 reporting period, Webprod Ltd purchased $1 084 846
of factory plant and equipment of which $30 000 of this amount is included in the accruals liability.
Of the closing accruals balance of $163 000 shown in the statement of financial position, $30 000 relates
to the purchase of factory plant and equipment. This $30 000 accrual will be reflected in the cash flows
from investing section of the statement of cash flows. For this reason, the $30 000 accrual is excluded
from the $163 000 closing balance.
Step 5: Increase in prepayments

In some instances, an entity will also prepay operating expenses. This will be reflected in
the prepayments account in the current asset section in the statement of financial position.
Examples include prepaid rent and prepaid insurance. While they are reflected as current
assets, these prepayments relate to payments of operating expenses and, as such, need to
be included as part of the payments to suppliers figure in the net cash flows from operating
activities in the statement of cash flows.
If the amount of prepayments increases during the reporting period, then the increase needs
to be reflected as an additional cash outflow in the statement of cash flows.
It will be observed that there was an increase in the prepayments balance in the statement
of financial position from $22 500 (see Case study data Section 1) to $58 800 (see Case study
data Section 8). An increase in prepayments indicates that the payments of operating expenses
exceed the amount of operating expenses incurred in the P&L and OCI. This increase of $36 300
needs to be included in determining the payments to suppliers.
Step 6: Determining under-applied overhead expense paid in cash

The final step is to determine the amount of cash paid in relation to under-applied overhead.
The amount of overhead allocated to work in process totalled $1 624 487 (see Section 2.2.2 of
Case study data. The under-applied overhead expense as shown in Case study data Section 8 is
$87 500. This gives a sub-total of $1 711 987 ($1 624 487 + $87 500).
Those expenses included in this sub-total of overheads that were non-cash expenses must be
excluded. In this particular case study, there are two non-cash expenses that are included in
overhead expenses that must be excluded, namely:
$
• employee benefits (refer Section 4 of ‘Case study data’) 665 281
MODULE 2
• depreciation expense of factory and plant† 221 862
Total: 887 143
†
Refer to Section 3.2 of ‘Case study data’ (depreciation of factory buildings $100 000 + depreciation of
factory plant and equipment $121 862).
Therefore, the total cash expenses related to under-applied overhead is $824 844 ($1 711 987 –
$887 143).
Putting it all together:
The total amount of payments to suppliers of $15 216 421 comprises:

$
Cash paid to the suppliers of inventories 7 984 200 †
Operating expenses paid 6 371 077 ‡
Increase in prepayments 36 300 §
Under-applied overhead expense 824 844 #
Total: 15 216 421
†
See step 3: Determining the amount of cash paid to the suppliers of inventories.
‡
See step 4: Determining the amount of operating expenses paid.
§
See step 5: Increase in prepayments.
#
See Step 6: Determining under-applied overhead expense paid in cash.
This represents a cash outflow from operating activities.
4. Cash paid to employees: $3 272 000

Refer to Section 4 of the ‘Case study data’, which states that:
During the 20X7 financial year, the total payments for wages and salaries, including annual leave,
totalled $3 250 000. Long service leave paid during the same period amounted to $22 000.
Therefore, total employee benefits paid were $3 272 000.
5. Borrowing costs: $118 350

In determining the total cash paid for borrowing cost, apart from the amount noted in the expense
item, it is also important to take into consideration the items noted in the statement of financial
position such as the movement in prepaid borrowing costs and capitalised borrowing costs.
(a) Borrowing cost paid: $108 204

In order to determine the amount of borrowing costs paid, the following formula may be used:
Closing balance of + Borrowing cost − Opening balance of

prepaid borrowing costs expenses prepaid borrowing costs
The amount of borrowing costs paid is calculated as follows:

$
Closing balance of prepaid borrowing costs† 4 550
Plus: Borrowing cost expenses‡ 103 654
MODULE 2
(108 204 )
Less: Opening balance of prepaid borrowing costs —
Borrowing cost expenses paid 108 204
†
See Section 5 of the Case study data.
‡
See Section 5 of the Case study data.
(b) Capitalised borrowing costs paid: $10 146

In addition to the borrowing cost payments identified above, Webprod Ltd included $10 146
(see Section 5 of the Case study data) of borrowing costs as part of plant under construction
during the 20X7 reporting period. This represented a change in accounting policy.
This $10 146 capitalised borrowing costs paid is added to the borrowing cost paid of $108 204
calculated above to give total borrowing costs paid of $118 350.
6. Warranties paid: $8800

In order to determine the amount of warranties paid, the following formula may be used:
Opening balance of + Warranties − Closing balance of

provision for warranties expense provision for warranties
The amount of warranty payments is calculated as follows:

$
Opening balance of provision for warranties† 45 500
Plus: Warranty expense‡ 12 300
57 800
Less: Closing balance of provision for warranties§ (49 000 )
Warranties paid 8 800
†
Provision for warranties: current $10 500 and non-current $35 000 (see Section 1 of Case study data).
‡
See Section 8 of Case study data.
§
Provision for warranties: current $11 000 and non-current $38 000 (see Section 8 of Case study data).

7. Income tax paid: $120 000

Where there are no temporary differences (i.e. no DTAs and/or DTLs), then the opening balance
of current tax payable is usually the amount of income tax paid during the current period.
In order to determine the amount of income tax paid, the following formula may be used:
Opening balance of + Income tax − Closing balance of

current tax payable expense current tax payable
The amount of income tax paid is calculated as follows:

MODULE 2
$
Opening balance of current tax payable† 120 000
Plus: Income tax expense‡ 387 018
507 018
Less: Closing balance of current tax payable§ (387 018 )
Income tax paid 120 000
†
‡

8. Interest received: $11 467
In order to determine the amount of interest received, the following formula may be used:
Closing balance of + Interest revenue − Opening balance of

unamortised debenture unamortised debenture
discount discount
The amount of interest received is calculated as follows:

$
Closing balance of unamortised debenture discount 897
Plus: Interest revenue 12 283
13 180
Less: Opening balance of unamortised debenture discount (1 713 )
Interest received 11 467
This represents a cash inflow from investing activities.

9. Proceeds from sale of factory plant and equipment: $88 000

Refer to Section 3.1 of the ‘Case study data’, which states that:
On 1 December 20X6, factory plant and equipment with a carrying amount of $63 000
(cost $160 000) was sold for $88 000. The profit or loss on sale is based on the carrying amount
of the plant at the start of the reporting period.
The gain on the sale of $25 000 is shown in the P&L and OCI. However, this is a non-cash gain.
The proceeds from the sale of factory plant and equipment totalled $88 000. This represents
a cash inflow from investing activities.
MODULE 2
10. Purchase of factory plant and equipment: $1 052 700
Refer to Section 3.1 of the ‘Case study data’, which states that during the 20X7 financial year:
• On 20 August 20X6, retail fixtures and fittings were purchased at a cost of $8000.
• During the 20X7 reporting period, Webprod Ltd purchased $1 084 846 of factory plant and
equipment; $30 000 of this amount is included in the liability for accruals.
Purchase of factory plant and equipment ($) $ $

Retail fixtures and fittings† 8 000
Factory plant and equipment† 1 084 846
Subtotal 1 092 846
Less
Accruals† 30 000
Capitalised borrowing costs‡ 10 146
Cash payment for factory plant and equipment 1 052 700

†
See Section 3.1 of Case study data.

‡
Moreover, $10 146 worth of capitalised borrowing costs paid has already been included as an
operating cash outflow and, to avoid double counting, cannot be included as an investing cash
outflow. This represents a cash outflow from investing activities.
11. Loan to director: $6000

In order to determine the amount of the loan to the director, the following formula may be used:
Closing balance of − Opening balance of

director loan director loan
(asset) (asset)
The amount of the loan to the director is calculated as follows:

$
Closing balance of director loan account (asset) 78 000
Less: Opening balance of director loan account (asset) (72 000 )
Loan made to director 6 000
This represents a cash outflow from investing activities.

12. Cash paid for product development costs (R&D expenditure): $380 000
The product development costs of $380 000 that were capitalised as an intangible asset
(that form part of R&D expenditure. As per Note 7 of the 20X7 Trial Balance, $380 000 was
paid already) in the statement of financial position is shown separately as a cash outflow from
investing activities.
In order to determine the amount of monies spent on capitalised product development costs,
the following formula may be used:

product development product development
MODULE 2
costs costs
The amount of monies spent on capitalised product development costs is calculated as follows:
$
Closing balance of product development costs 380 000
Less: Opening balance of product development costs —
Payment for product development costs 380 000
This represents a cash outflow from investing activities.

13. Proceeds from funds borrowed: $400 000
In order to determine the amount of funds borrowed, the following formula may be used:

loan—Finance Ltd loan—Finance Ltd
The amount of funds borrowed is calculated as follows:

$
Closing balance of loan—Finance Ltd 400 000
Less: Opening balance of loan—Finance Ltd —
Funds borrowed 400 000
This represents a cash inflow from financing activities.
14. Dividends paid: $260 000

In order to determine the amount of dividends paid, the following formula may be used:
Opening balance of + Interim + Final − Closing balance of

final dividend dividend dividend final dividend
payable (liability) payable (liability)
The amount of dividends paid is calculated as follows:

$
Opening balance of final dividend payable (liability)† 60 000
Plus: Interim dividend‡ 200 000
Plus: Final dividend‡ 250 000
510 000
Less: Closing balance of final dividend payable (liability)‡ (250 000 )
Dividends paid 260 000

†

‡
Interim dividend $200 000, final dividend $250 000 and final dividend payable $250 000 (see Section 8
of Case study data).
MODULE 2
This represents a cash outflow from financing activities.
15. Repayment of bank loan: $100 000

In order to determine the amount of the repayment of the bank loan, the following formula
may be used:
Opening balance of − Closing balance of

bank loan—secured bank loan—secured
The amount of the repayment of the bank loan is calculated as follows:

$
Opening balance of bank loan† 1 000 000
Less: Closing balance of bank loan‡ (900 000 )
Payment of bank loan 100 000

†
Opening balance of bank loan $1 000 000 (current liability $100 000 + non-current liability $900 000,
as per Section 1 of Case study data)

‡
Closing balance of bank load loan $900 000 (current liability $100 000 + non-current liability $800 000,
as per Section 8 of Case study data)
16. Payment of promissory notes: $65 000

In order to determine the amount of the repayment of promissory notes, the following formula
may be used:
Opening balance of − Closing balance of

promissory notes promissory notes
The amount of the repayment of promissory notes is calculated as follows:

$
Opening balance of promissory notes 300 000
Less: Closing balance of promissory notes (235 000 )
Payment of promissory notes 65 000
Webprod Ltd
Statement of cash flows for the reporting period ended 30 June 20X7
$
Note Inflows
(Outflows)
Cash flows from operating activities (IAS 7, paras 10, 14, 18)
Cash received from customers 19 535 264
Cash received from grants 750 000
Cash paid to suppliers (15 216 421 )
MODULE 2
Cash paid to employees (3 272 000 )

Borrowing costs paid (IAS 7, para. 31) (118 350 )
Warranties paid (8 800 )
Income tax paid (IAS 7, para. 35) (120 000 )
Net cash flows from operating activities 4 1 549 693
Cash flows used in investing activities (IAS 7, paras 10, 16, 21)
Interest received (IAS 7, para. 31) 11 467
Proceeds from sale of factory plant 88 000
Purchase of factory plant and retail fixtures and fittings (1 052 700 )
Loan to director (6 000 )
Cash paid for product development costs (380 000 )
Net cash used in investing activities (1 339 233 )
Cash flows from financing activities (IAS 7, paras 10, 17, 21)
Proceeds from funds borrowed 400 000
Dividends paid (IAS 7, para. 31) (260 000 )
Payment of bank loan (100 000 )
Payment of promissory notes (65 000 )
Net cash flows used in financing activities 5 (25 000 )
Net increase in cash and cash equivalents 185 460

Cash and cash equivalents at the beginning of the period 6 713
Cash and cash equivalents at the end of the period 1 192 173
Notes to the statement of cash flows:

1. Components of cash and cash equivalents (IAS 7, para. 45)
For the purpose of the statement of cash flows, cash includes cash on hand and at banks and
short-term deposits at call, net of outstanding bank overdrafts (IAS 7, para. 46). Cash and
cash equivalents at the end of the financial year, as shown in the statement of cash flows,
are reconciled to the related items in the statement of financial position as follows:
Cash at bank: $192 173
2. Non-cash financing and investing activities (IAS 7, para. 43)
There were no non-cash financing and investing activities during the current period.
3. Financing facilities (IAS 7, para. 50) (see notes at the end of Section 1 of the Case study data).
Bank overdrafts
The company has access to bank overdrafts to a maximum of $200 000, which is secured by
a first mortgage over Webprod Ltd land and buildings. The bank overdraft has not been used
by Webprod Ltd during 20X7. The overdraft bears an interest rate of 8 per cent.
Bank term loan

Webprod Ltd has a 10-year bank loan secured by a first mortgage over the land and buildings
of Webprod Ltd. The bank loan has an effective interest rate of 7 per cent.
Credit standby arrangements
MODULE 2
A bank standby facility of $200 000 is available to Webprod Ltd. This bank standby facility
bears interest at 9 per cent.
4. Reconciliation of net profit for the period to the net cash provided by operating activities:
$
Net profit after tax for the period 903 041
Non-cash adjustments
Depreciation included in overhead 221 862
Write-down of inventory 24 921
Profit—factory plant (25 000 )
Non-operating activity adjustments

Interest revenue (12 283 )
Borrowing costs capitalised (10 146 )
Add/Less: $
Increase in net trade receivables (255 370 )
Increase in grant receivable (250 000 )
Increase in work in process (24 140 )
Increase in finished goods (25 700 )
Increase in retail inventory (18 598 )
Increase in prepaid borrowing costs (4 550 )
Increase in prepayments (36 300 )
Increase in allowance for doubtful debts 1 600
Decrease in raw materials 8 680
Increase in trade payables 2 500
Increase in accruals 9 000 †
Increase in employee benefits 54 404
Increase in warranty provision 3 500
Increase in provision for damages 620 000
Increase in tax payable 267 018
Net cash provided by operating activities 1 549 693

†
Excludes increase in accruals from construction of factory plant $30 000 because this amount has
also been excluded in the calculation of operating expenses in Part 3, Item 4.
5. Reconciliation of liabilities arising from financing activities (IAS 7 44A–E)
(Note that you may want to refer to Section 1 Case study data for the closing balance of
liabilities related to financing activities as at 30 June 20X6, the cash flows from financing
activities in answer to Question 2.11 and the solution to Question 2.10 Statement of financial
position for Webprod Ltd as at 30 June 20X7.)
Reconciliation of liabilities arising from financing activities
Non-cash
01.07.X6 Cash flows changes 30.06.X7
Current liabilities—financing activities
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Final dividend payable 60 000 (260 000) 450 000 250 000
Bank loan—secured 100 000 — — 100 000
Non-current liabilities—financing activities

Bank loan—secured 900 000 (100 000) — 800 000
Promissory note 300 000 (65 000) 235 000
Loan—Finance Ltd — 400 000 400 000
Preference shares 100 000 — — 100 000
Total 1 460 000 (25 000) 450 000 1 885 000
6. Cash not available for use (IAS 7, para. 48)
There were no restrictions on use of cash held as at 30 June 20X7.

References | 193
References
References
MODULE 2
AASB (Australian Accounting Standards Board) 2004, Framework for the Preparation and
Presentation of Financial Statements, accessed November 2017, http://www.aasb.gov.au/admin/
file/content105/c9/Framework_07-04nd.pdf.
BHP Billiton 2014, Value through Performance: Annual Report 2014, accessed November
2017, http://www.bhpbilliton.com/~/media/bhp/documents/investors/annual-reports/
bhpbillitonannualreport2014.pdf.
MODULE 2
FINANCIAL REPORTING
Module 3
REVENUE FROM CONTRACTS WITH
CUSTOMERS; PROVISIONS, CONTINGENT
LIABILITIES AND CONTINGENT ASSETS
196 | REVENUE FROM CONTRACTS WITH CUSTOMERS; PROVISIONS, CONTINGENT LIABILITIES AND CONTINGENT ASSETS
Contents
Preview 197
Introduction
Objectives
Teaching materials
Part A: Revenue from contracts with customers

199
Introduction 199
Existing practice
Overview of IFRS 15 Revenue from Contracts with Customers
Recognition of revenue 204
Step 1: Identify the contract(s) with the customer
Step 2: Identify the performance obligation(s) in the contract
Step 3: Determine the transaction price of the contract
Step 4: Allocate the transaction price to each performance obligation
Step 5: Recognise revenue when each performance obligation is satisfied
Contract costs 223
Incremental costs of obtaining a contract
Costs to fulfil a contract
Amortisation and impairment
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Disclosure 226
Contracts with customers
Significant judgments in the application of IFRS 15 Revenue from Contracts
with Customers
Assets recognised from contract costs
Summary 229
Part B: Provisions
230
Introduction 230
Scope of IAS 37 Provisions, Contingent Liabilities and Contingent Assets
Definition of provisions
Recognition of provisions 232
Measurement of provisions 235
Discounting
IAS 37—Provisions, Contingent Liabilities and Contingent Assets:
Disclosure 237
Provisions
Exemptions
Provisions and professional judgment 239
Summary 240
Part C: Contingent liabilities and contingent assets

241
Introduction 241
Contingent assets 241
Recognition of assets
Contingent assets
Contingent liabilities 243
Liabilities versus contingent liabilities
Contingencies and professional judgment 246
Summary 246
Review 247
References 255
Optional reading
Study guide | 197
Module 3:
Revenue from contracts
with customers; Provisions,
contingent liabilities and
contingent assets
Study guide
MODULE 3
Preview
Introduction
This module examines accounting for revenue from contracts with customers, provisions,
and contingent liabilities and contingent assets. These items have been an area of much
discussion, not only within the accounting profession, but also among financial statement
users, especially in relation to satisfying their information needs.
In particular, the timing and amount of revenue recognised by entities has been criticised
because of a lack of comparability in the revenue recognition practices being used and the
insufficient disclosure of revenue-related information (IFRS 15 Basis for Conclusions, paras BC2
and BC327). Public interest in these issues has been sparked by the sensitive nature of
revenue recognition.
In response to these concerns, International Financial Reporting Standard 15 Revenue from

Contracts with Customers (IFRS 15) was issued in 2014. IFRS 15 will be effective for financial
reporting periods beginning on or after 1 January 2018, and earlier application is permitted.
As such, it is important to examine revenue recognition in the context of IFRS 15, as existing
revenue recognition standards will be phased out and superseded by this new standard.
IFRS 15 introduces a five-step model of revenue recognition that is capable of general application
to a variety of transactions and requires more detailed revenue-related disclosures. IFRS 15 is
expected to enhance the financial reporting of revenue. Part A of this module discusses the five
step model and disclosure requirements of IFRS 15.
The introduction of standards relating to provisions, contingent liabilities and contingent assets
has also led to a tightening of accounting practice. International Accounting Standard 37
Provisions, Contingent Liabilities and Contingent Assets (IAS 37) was issued in 1998 effective
for financial periods beginning on or after 1 July 1999. IAS 37 significantly reduced the ability
of entities to use provisions as a means of managing the timing of the recognition of expenses,
because the standard requires a present obligation to exist before any provision (and related
expense) can be recognised. This is discussed in Part B of this module.
Accounting for provisions raises a number of recognition and measurement issues, particularly
in relation to the present obligation and reliable measurement criteria. Further, for provisions
extending over more than one reporting period, the issue of discounting future cash flows
introduces further measurement issues, including the appropriateness of the discount rate.
Part C of this module discusses these recognition and measurement requirements in relation
to contingent assets and contingent liabilities. Although IAS 37 indicates that neither may be
recognised in the statement of financial position (with the exception of some contingent liabilities
in a business combination), it clarifies the nature of these potential obligations and benefits,
and outlines disclosure requirements.
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Overall, the main aim of IFRS 15 and IAS 37 is to ensure that the financial reporting of revenue
from contracts with customers, provisions, contingent liabilities and contingent assets is
informative for financial statement users. For example, the revenue-related disclosures
under IFRS 15 provide users with an understanding of the revenue practices of the entity.
This understanding extends to how recognised revenue is earned, at what stage of the activity
the revenue is earned and when payment is typically received, as well as to when and how
remaining revenue from existing contracts will be recognised in the future. IAS 37 ensures
that appropriate recognition criteria and measurement principles are applied to provisions
recognised in financial statements. The standard also ensures that disclosures are sufficient to
enable users to understand the nature, timing and amount of provisions, contingent liabilities
and contingent assets.
Objectives
The overall aim of this module is to provide you with a working knowledge of the issues associated
with accounting for revenue from contracts with customers, provisions, and contingent liabilities
and contingent assets. At the end of this module, you should be able to:
• explain and apply the requirements of IFRS 15 with respect to contract(s) with customers;
• determine and allocate the transaction price of a contract to the performance obligation(s)
of the contract; and
• understand, and be able to apply IAS 37 as it relates to a provision, contingent liability and
contingent asset, and recognise how they relate to the Framework.
Teaching materials
• Conceptual Framework for Financial Reporting (2010)
• IAS 37 Provisions, Contingent Liabilities and Contingent Assets
• IFRS 15 Revenue from Contracts with Customers
Study guide | 199
Part A: Revenue from contracts

with customers
Introduction
Part A reviews the recognition and disclosure requirements of IFRS 15 Revenue from Contracts
with Customers. Previous revenue standards have been criticised, particularly in relation to a lack
of clarity and guidance in their application to more complex transactions, which has led entities
to adopt inconsistent revenue recognition practices. Concerns have also been raised about the
inadequate disclosure requirements of previous revenue standards, which have contributed to
financial statement users’ lack of understanding about an entity’s revenue practices. With the
objective of improving the financial reporting of revenue, IFRS 15 establishes principles for
reporting useful information to financial statement users about the nature, amount, timing and
uncertainty of revenue and cash flows from an entity’s contracts with customers. The aim of
these principles is to provide a framework of broad revenue recognition concepts that can
be consistently applied to a wide range of transactions and industries. The IFRS 15 principles
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also aim to provide important information for financial statement users to make an informed
assessment of an entity’s revenue-earning capabilities.
A key indicator of an entity and its management’s current performance is the revenue generated
from its activities. Moreover, revenue that is to be generated in future periods acts as a signal
of future performance. Providing information about an entity’s current and future revenue from
contracts with customers allows users to understand how the entity is currently performing and
its performance capacity in the future. Such information is important to help financial statement
users with their decision-making. Existing and potential investors in an entity, for example,
require information on an entity’s revenue-earning capacity to evaluate their potential return
on investment and decide whether to buy, hold or sell shares in the entity.
Employees may also rely on information about their employer entity’s revenue to assess their
future job security. Accordingly, it is critical that users have information on an entity’s revenue-
earning activities. By unifying the revenue recognition practices of entities and requiring detailed
disclosures of revenue earned in the current period and revenue from existing contracts to
be earned in future periods, IFRS 15 helps financial statement users to not only make more
informed assessments of an entity’s revenue-earning capabilities, but also of an entity’s
performance relative to other entities.
Part A begins with a discussion of existing revenue standards and provides an overview of
IFRS 15, including an outline of its scope and effective date. The recognition of revenue
under IFRS 15 is then discussed, with an emphasis on the five-step revenue recognition model,
which entities are to apply in determining the timing and amount of revenue to be recognised.
Part A concludes with a discussion on disclosure requirements relating to revenue from
contracts with customers.
Existing practice
At present, IAS 18 Revenue (IAS 18) outlines the accounting requirements for the amount of
revenue to recognise and timing of when to recognise revenue arising from the sale of goods;
rendering of services; and use by others of the entity’s assets that yield interest, royalties and
dividends for the entity. However, where the services rendered relate to construction contracts,
revenue is to be recognised in accordance with IAS 11 Construction Contracts (IAS 11).
Under IAS 18, revenue is to be measured at the fair value of the consideration received or
receivable, net of any trade discounts or volume rebates offered by the entity (IAS 18, paras 9
and 10).
Revenue from the sale of goods shall be recognised when all the following conditions have
been satisfied:
• the entity has transferred to the buyer the significant risks and rewards of ownership of
the goods;
• the entity retains neither continuing managerial involvement to the degree usually associated
with ownership nor effective control over the goods sold;
• the amount of revenue can be measured reliably;
• it is probable that the economic benefits associated with the transaction will flow to the
entity; and
• the costs incurred or to be incurred in respect of the transaction can be measured reliably
(IAS 18, para. 14).
Typically, the transfer of the significant risks and rewards of ownership of the goods and the
transfer of control of the goods sold occur when legal title or possession passes to the buyer.
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As such, revenue from the sale of goods is recognised at a point in time, generally when the
goods are delivered to the customer, which may be at the point of sale or not long afterwards.
In contrast, revenue from the rendering of services is recognised according to the transaction’s
stage of completion at the end of the reporting period, provided that the transaction’s outcome
can be estimated reliably. According to IAS 18:
The outcome of a transaction can be estimated reliably when all of the following conditions
are satisfied:
(a) the amount of revenue can be measured reliably;
(b) it is probable that the economic benefits associated with the transaction will flow to the entity;
(c) the stage of completion of the transaction at the end of the reporting period can be measured
reliably; and
(d) the costs incurred for the transaction and the costs to complete the transaction can be
measured reliably (IAS 18, para. 20).
These conditions indicate that revenue arising from rendering services is to be recognised
over time, according to the degree (or percentage) of completion of the services at the end of
each accounting period in which the services are rendered. To recognise revenue for rendering
services, however, the entity must be able to reliably measure the amount of revenue, stage of
completion of the services, and costs incurred and to be incurred in rendering the services.
Further, it must be probable that the economic benefits from rendering the services will flow
to the entity.
Similar to the recognition of revenue from rendering services, revenue in the form of interest,
royalties and dividends shall only be recognised when:
(a) it is probable that the economic benefits associated with the transaction will flow to the
entity; and
(b) the amount of the revenue can be measured reliably (IAS 18, para. 29).
One criticism of IAS 18 is the lack of guidance the standard provides to entities trying to apply
it (IFRS 15 Basis for Conclusions, para. BC2(b)). To assist these entities, the IFRS Interpretations
Committee has issued IFRIC Interpretations to provide guidance on the application of IAS 18,
including IFRIC 13 Customer Loyalty Programmes.
Study guide | 201
As discussed in greater detail below, it is this lack of guidance that has contributed to entities
adopting diverse revenue recognition practices when accounting for contracts with customers.
IFRS 15 aims to standardise these practices by providing a comprehensive framework, with detailed
application guidance, on revenue recognition.
In addition to replacing IAS 18, IFRS 15 also replaces:

• IAS 11 Construction Contracts
• IFRIC 13 Customer Loyalty Programmes
• IFRIC 15 Agreements for the Construction of Real Estate
• IFRIC 18 Transfers of Assets from Customers
• SIC-31 Revenue–Barter Transactions Involving Advertising Services.
Overview of IFRS 15 Revenue from Contracts with Customers

As mentioned above, the purpose of IFRS 15 is to overcome the deficiencies of previous
revenue standards and provide a comprehensive single model for revenue recognition that can
be consistently applied by all entities to their contracts with customers. Under International
Financial Reporting Standards (IFRSs), diversity exists in entities’ revenue recognition practices.
In contrast, previous revenue standards contained little guidance on how to account for
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transactions other than simple transactions. For example, consider an entity that enters into
a contract with a customer for the sale of goods that allows the customer a right of return for a
specified period. In accounting for the sales contract, the entity needs to consider not only when
to recognise revenue, but also the amount to be recognised as revenue, because the customer
is expected to exercise, to some degree, its right of return. Previous revenue standards provided
little guidance to entities on how to account for these and other multiple-element arrangements.
As a consequence, entities supplemented the limited guidance in IFRS by applying US Generally
Accepted Accounting Principles (US GAAP), which contain industry- and transaction-specific
requirements. The US GAAP requirements, however, have been acknowledged as containing
inconsistencies in the recognition of revenue for economically similar transactions (IFRS 15
Basis for Conclusions, para. BC3).
In addition, the disclosure requirements in previous revenue standards were criticised for
not providing sufficient information for users to understand the entity’s revenue practices,
including the judgments and estimates made in recognising that revenue. For example,
feedback from users in the development of IFRS 15 indicated that entities’ revenue-related
disclosures were often generic or boilerplate in nature or presented in isolation, with no
explanation of how the revenue recognised related to other financial statement information.
IFRS 15 requires a comprehensive five-step revenue recognition model to be applied by

entities to all their customer contracts. IFRS 15 is intended to improve the financial reporting
of revenue by:
• providing a more robust framework for addressing revenue recognition issues;
• improving comparability of revenue recognition practices across entities, industries,
jurisdictions and capital markets;
• simplifying the preparation of financial statements by reducing the amount of guidance
to which entities must refer; and
• requiring enhanced disclosures to help users of financial statements better understand
the nature, amount, timing and uncertainty of revenue that is recognised (IFRS 15 Basis for
Conclusions, para. BC3).
To assist entities in applying IFRS 15, the new standard provides guidance on how to account
for numerous contract types and their elements, including:
• contracts with a right of return period
• warranties
• contracts in which a third party provides the goods or services to the customer
(principal versus agent considerations)
• contracts with options for customers to purchase additional goods or services at a
discount or free of charge
• customer prepayments and payment of non-fundable upfront fees
• licensing and repurchase agreements
• consignment and bill-and-hold arrangements.
Scope of IFRS 15
IFRS 15 applies to all contracts with customers, except those contracts that are (in their entirety
or in part):
• lease contracts within the scope of IAS 16 Leases;
• insurance contracts within the scope of IFRS 4 Insurance Contracts;
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• financial instruments and other contractual rights or obligations within the scope of IFRS 9
Financial Instruments, IFRS 10 Consolidated Financial Statements, IFRS 11 Joint Arrangements,
IAS 27 Separate Financial Statements and IAS 28 Investments in Associates and Joint
Ventures; and
• non-monetary exchanges between entities in the same line of business to facilitate sales to
customers or potential customers (IFRS 15, para. 5).
A contract with a customer may be partially within the scope of IFRS 15 and partially within the
scope of one of the above standards. In such cases:
• If the other standards specify how to separate or initially measure one or more parts of
the contract, then an entity shall apply those separation or measurement requirements first.
The transaction price of the contract is then reduced by the amounts initially measured
under the other standards, with the remaining transaction price being accounted for under
IFRS 15. The term ‘transaction price’ is discussed below.
• If the other standards do not specify how to separate or initially measure one or more parts
of the contract, then an entity shall apply IFRS 15 to the contract (IFRS 15, para. 7).
Example 3.1: Scope of IFRS 15

An entity enters into a lease agreement (as the lessor) with another entity (the lessee) for the lease of
equipment. The annual payments made by the lessee include lease payments and a fee for ongoing
service and maintenance of the equipment, as provided by the lessor. From the perspective of the
lessor, the contract with the lessee is partially within the scope of IAS 16 Leases (IAS 16) (in relation
to the lease payments) and partially within IFRS 15 (in relation to the service and maintenance fee).
In accordance with para. 7 of IFRS 15, the lessor shall apply IAS 16 first to measure the lease receivable
arising from the lease payments. This amount is deducted from the transaction price of the lease
agreement and the remaining amount, being the service and maintenance fee, is accounted for by
the lessor applying the five-step model of revenue recognition in IFRS 15.
The scope of IFRS 15 also extends to the recognition and measurement of gains and losses
on the sale of non-financial assets that are not an output of an entity’s ordinary activities.
As such, IFRS 15 applies to the sale of assets previously governed by IAS 16 Property,
Plant and Equipment, IAS 38 Intangibles and IAS 40 Investment Property.
Study guide | 203
Impact of IFRS 15
The impact of IFRS 15 will vary by industry. For entities in some industries, there may be little
change in the timing and amount of revenue recognised. For entities in other industries, however,
significant changes may occur. For example, entities in the telecommunications industry are likely
to be significantly affected by IFRS 15. For instance, telecommunications entities may provide
customers with a ‘free’ handset that they can use in return for entering into a monthly payment
plan for a minimum period. IAS 18 provides little guidance on how to recognise revenue from
contracts for the bundled offer of a good and service. As a result, some telecommunication
entities recognise revenue from the sale of the monthly plans when the service is provided
and treat the handsets as a marketing expense. Others treat the handset as a cost of acquiring
the customer and amortise it over the minimum contract period. Neither of these options is
permitted under IFRS 15, and as a result, telecommunication entities must allocate the total
contract price between the sale of the handset and the monthly plan. This will change when
these entities recognise revenue, with revenue allocated to the handset now being recognised
earlier (i.e. at the time of its sale).
Similar to entities in the telecommunications industry, those in the software development and
technology industries will also need to allocate the contract price between the goods and/or
services in a bundled offer. Software entities may enter into contracts with customers for the
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implementation, customisation and testing of software, with post-implementation support.
Under IAS 18, software entities would recognise revenue by reference to the stage of completion
of the transaction, including post-implementation services. Under this approach, software entities
would not be required to allocate the total contract price between each of the services provided.
Rather, the revenue would be recognised according to the percentage of completion of the
services as a whole. IFRS 15, however, requires the contract price to be allocated to each distinct
service, with revenue recognised when that service is completed. This will alter the timing of
revenue recognised by software entities.
IFRS 15 also contains detailed requirements related to when a change in the terms of a
contract should be treated as a separate contract or as a modification to an existing contract.
IAS 18, however, does not provide such guidance, resulting in entities accounting for contract
modifications differently. For entities such as manufacturers, whose contracts can be modified
to require the delivery of additional goods or services to the customer at an increased price,
IFRS 15 has the potential to change how they account for revenue when a contract is modified.
Finally, IFRS 15 imposes stringent requirements that must be satisfied before revenue can be
recognised progressively over time. This has a particular impact on entities that have previously
recognised revenue on long-term contracts over time, such as construction entities that employ
the stage of completion method. If the IFRS 15 requirements are not satisfied, these entities
would recognise revenue at a point in time, for example, when the service is complete.
Overall, the practical implications of IFRS 15 are that the timing and amount of revenue recognised
from contracts with customers will change for some entities that have been applying previous
revenue standards (i.e. IAS 18 and IAS 11). This is because some entities will be required to
alter their accounting treatment of items such as contracts for bundled goods and services,
contract modifications and contracts that are satisfied over time.
Effective date
Issued on 28 May 2014, IFRS 15 originally applied to annual reporting periods beginning on or
after 1 January 2017. However, the effective date of IFRS 15 has been deferred by one year; it will
now apply to annual reporting periods beginning on or after 1 January 2018. Early application
of IFRS 15 is permitted, although an entity must disclose the fact it has applied IFRS 15 early
(IFRS 15, para. C1).
In May 2016, the IASB issued Clarifications to IFRS 15 Revenue from Contracts with Customers,
which amends IFRS 15 to address implementation issues arising from IFRS 15. The amendments
are effective for annual reporting periods beginning on or after 1 January 2018, and relate to the
following topics:
• identifying performance obligations
• principal versus agent considerations
• the timing of recognising revenue from granting a licence.
The identification of performance obligations is a topic covered within this module, which has
been updated to reflect these amendments.
Recognition of revenue
IFRS 15 establishes a framework for determining when to recognise revenue and how much
revenue to recognise. Within that framework, the core principle of IFRS 15 is that an entity
should recognise ‘revenue to depict the transfer of promised goods or services to customers in
an amount that reflects the consideration to which the entity expects to be entitled in exchange
for those goods or services’ (IFRS 15, para. 2). To apply this core principle, an entity needs to
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adopt a five-step model for each customer, as illustrated by Figure 3.1.
Figure 3.1: IFRS 15 Revenue from Contracts with Customers five-step model
STEP 1
Identify the contract(s) with the customer
STEP 2
Identify the performance obligation(s) in the contract
STEP 3
Determine the transaction price of the contract
STEP 4
Allocate the transaction price to each performance obligation
STEP 5
Recognise revenue when each performance obligation is satisfied
Source: Based on IFRS Foundation 2017, IFRS 15 Revenue from Contracts with Customers,
para. IN7, in 2017 IFRS Standards, IFRS Foundation, London.
Study guide | 205
When applying the five-step model, the entity must consider the terms of each contract and all
relevant facts and circumstances. The entity must also apply the five-step model consistently to
contracts that are similar in character and circumstance (IFRS 15, para. 3).
This section now looks at each step in detail.
Step 1: Identify the contract(s) with the customer

In carrying out step 1, an entity must identify its customers and then the contracts it has with
its customers. First, IFRS 15 defines a customer as ‘a party that has contracted with an entity
to obtain goods or services that are an output of the entity’s ordinary activities in exchange for
consideration’ (IFRS 15, Appendix A). Under this definition, not all parties with whom the entity
enters into a contract are customers for IFRS 15 purposes: the definition is limited to those
parties that obtain, in exchange for consideration, the output of the entity’s ordinary activities.
If the counterparty to a contract is not a customer, the contract is outside the scope of IFRS 15.
Second, a contract is ‘an agreement between two or more parties that creates enforceable
rights and obligations’ (IFRS 15, Appendix A). The agreement can be written, oral or implied by
an entity’s customary business practices. Provided the contract is within the scope of IFRS 15
(see ‘Scope of IFRS 15’ in the ‘Introduction’ section above), an entity shall apply the requirements
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of IFRS 15 to each contract that has all of the following attributes:
• the parties have approved the contract and are committed to perform their obligations
• the entity can identify each party’s rights regarding, and the payment terms for, the goods
or services to be transferred
• the contract has ‘commercial substance’
• it is likely that the entity will collect the consideration that it is entitled to in exchange for
the goods or services that it transfers to the customer (IFRS 15, para. 9).
If the contract has all of the above attributes, the entity can proceed to step 2 of the five-step
model. An entity is not required to reassess whether these attributes remain present for the
duration of the contract unless there is an indication that the facts and circumstances have
changed significantly.
If the contract does not have all of the above attributes, IFRS 15 does not apply. An entity,
however, must continually reassess the contract to determine whether all attributes are present.
If they are all present, the entity can proceed to step 2 of the five-step model for this contract.
If you wish to explore this topic further you may now read paras 9–14 of IFRS 15.
Example 3.2: Counterparty to a contract is not a customer

A research centre enters into an agreement with a grantor that provides grants and sponsorship for
research activity. The agreement states the grantor cannot specify how any output from the research
activity will be used. This agreement is not a contract with a customer under IFRS 15 because the
grantor is not a customer of the research centre. As the grantor cannot specify how the output from
the research activity can be used, the grantor does not obtain the output of the research centre’s
ordinary activities in exchange for consideration (see IFRS 15, para. 6).
➤➤Question 3.1
Consider whether the following constitutes a contract with a customer under IFRS 15, and explain
why it does or does not:
• A construction company enters into a three-year agreement with a property developer for
the construction of a shopping centre. After 12 months, the property developer experiences
significant financial difficulties and is unlikely to meet future commitments.
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Combining multiple contracts

Paragraph 17 of IFRS 15 requires an entity to combine two or more contracts entered into at or
near the same time with the same customer and to account for them as one contract if at least
one of the following criteria is met:
• the contracts are negotiated ‘with a single commercial objective’
• the consideration ‘to be paid in one contract depends on the price or performance of the
other contract’, or
• ‘the goods or services promised in the contracts (or some goods or services promised in
each of the contracts) are a single performance obligation’ (defined in ‘Step 2: Identify the
performance obligation(s) in the contract’).
However, if the entity reasonably expects that the financial statement effects of accounting
for multiple contracts as a single contract will be materially different from accounting for the
contracts individually, the entity is not required to combine multiple contracts into one contract
(IFRS 15, para. 4).
If you wish to explore this topic further you may now read paras 4 and 17 of IFRS 15.
Contract modifications
A contract modification is a change in the scope or price (or both) of a contract that is approved
by both contracting parties. A contract modification exists when the contracting parties approve
a modification that creates new, or changes existing, enforceable rights and obligations of the
parties. Like the contract itself, the modification can be written, oral or implied by customary
business practices (IFRS 15, para. 18).
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Modification accounted for as a separate contract

If the modification has been approved by both contracting parties, it shall be accounted for as
a separate contract if both of the following conditions are met:
• the scope of the contract increases because of the addition of promised goods or services
that are ‘distinct’ (IFRS 15, para. 20(a)) (defined in ‘Step 2: Identify the performance
obligation(s) in the contract’)
• ‘the price of the contract increases by an amount of consideration that reflects the entity’s
stand-alone selling prices of the additional promised goods or services and any appropriate
adjustments to that price to reflect the circumstances of the particular contract’ (IFRS 15,
para. 20(b)). An example of price adjustment is when discounts are allowed to customers.
If both of these conditions are met, the entity will apply the remaining steps of the five‑step model
to the contract modification. The existing contract is unaffected by the contract modification,
as the revenue recognised to date under the existing contract (being the amounts associated
with those performance obligations already completed) is not adjusted. Future revenues related
to the remaining performance obligations under the existing contract will be accounted for under
the existing contract. Future revenues associated with the performance obligations remaining
under the contract modification will be accounted for separately.
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Example 3.3: Contract modification that is a separate contract
An entity promises to sell 100 widgets to a customer over 12 months for a transaction price of $5000
($50 per widget). The customer obtains control of each widget at the time of transfer. After six months,
the contract is modified to require the delivery of an additional 40 widgets at an additional price of
$1920 ($48 per widget). At the time of the modification, the entity had transferred control of 45 widgets
to the customer under the existing contract.
The contract modification is a new contract that is separate from the existing contract. The scope of
the contract has increased due to the promise of additional widgets that are distinct from the existing
widgets (IFRS 15, para. 20(a)). Moreover, the price of the additional widgets reflects their stand-alone
selling price at the time of the modification (IFRS 15, para. 20(b)).
Under IFRS 15, no adjustment is made to revenue recognised on the 45 widgets that have been
transferred to the customer ($2250). Following the modification, the entity will recognise revenue
separately for the 55 widgets remaining under the existing contract ($2750) and the 40 widgets
remaining under the additional contract ($1920).
in 2017 IFRS Standards, IFRS Foundation, London, pp. B1730–1.
Modification not accounted for as a separate contract

If neither of the conditions for a separate contract is met, how the contract modification is
accounted for depends on whether the remaining goods or services to be transferred under
the existing contract are distinct from those goods or services that were already transferred
before the contract modification. The three accounting approaches are outlined in the
following scenarios:
1. If they are distinct, the contract modification is accounted for as a replacement of
the existing contract with the creation of a new contract.
2. If they are not distinct, the contract modification is accounted for as part of the
existing contract.
3. If they are a combination of 1 and 2, the contract modification is accounted for as
partly the creation of a new contract and partly the modification of the existing contract
(IFRS 15, para. 21).
These distinction scenarios determine whether an entity is required to adjust previously

recognised revenue because of the contract modification. Under scenario 1, revenue recognised
to date under the existing contract is not adjusted. After the modification, the consideration
promised by the customer under the existing contract that has yet to be recognised as revenue
plus the consideration promised under the contract modification are allocated to the remaining
performance obligations in both the existing contract and the contract modification.
Remaining revenue is then recognised on a ‘prospective’ basis when these performance
obligations are completed.
Under scenario 2, the entity retrospectively adjusts recognised revenue to reflect the contract
modification’s effect on the transaction price and the entity’s progress towards completing
the performance obligation. This retrospective adjustment to recognised revenue would
typically arise when the existing contract relates to a single performance obligation that is
partially satisfied at the time of the modification. Depending on the modification’s effect on the
transaction price and the extent of progress, the adjustment may either increase or decrease
recognised revenue. After the modification, revenue is recognised according to the satisfaction
of the single performance obligation.
Scenario 3 applies when an entity modifies an existing contract in which some of the remaining
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goods or services to be transferred are distinct from those that have already been transferred.
If this is the case, the entity would adopt a combination of scenarios 1 and 2. In particular,
the entity applies scenario 1 to those goods or services that are distinct and scenario 2 to
those that are not.
Step 2: Identify the performance obligation(s) in the contract

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

a contract gives rise to a performance obligation. This applies whether the promise is explicit
within the contract or implied by the entity’s customary business practices. Promised goods or
services may give rise to a performance obligation even if the promise is incidental or part of an
entity’s marketing campaign. Examples include ‘free’ handsets provided by telecommunication
entities and customer loyalty points awarded by supermarkets, airlines and hotels.
If you wish to explore this topic further you may now read paras 22, 24 and 25 of IFRS 15.
Determining what is meant by ‘distinct’

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

IFRS 15 states a customer can benefit from a good or service through its use, consumption or
sale (for an amount greater than its scrap value) or if it is otherwise held in a way that generates
economic benefits. A customer may be able to benefit from the good or service on its own,
or in conjunction with other readily available resources. A readily available resource is a good
or service that is acquired separately from the entity or another party, or a resource that the
customer has already obtained from the entity under the contract or from other transactions
or events (IFRS 15, para. 28).
Separately identifiable promise to transfer a good or service

For a good or service to be distinct, the promise to transfer the good or service must be
separable from other promises in the contract. A promise is separable if the nature of the
promise, within the context of the contract, is to transfer goods or services individually rather
than as inputs to a combined item (or items). Indicators that two or more promises to transfer
goods or services are not separable include, but are not limited to, the following:
(a) The entity provides a significant service of integrating the goods or services with other goods
or services promised in the contract into a combined item or items (IFRS 15, para. 29 (a)).
(b) One or more of the goods or services significantly modifies or customises, or is significantly
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modified or customised by, one or more of the other goods or services promised in the
contract (IFRS 15, para. 29 (b))
(c) The goods or services are highly interdependent or highly interrelated (IFRS 15, para. 29 (c))
When the customer can derive benefit from a good or service that is separately identifiable,
as per IFRS 15, paras 27(a) and 27(b), the good or service is considered to be distinct. The entity
has a separate performance obligation for each distinct good or service within the contract.
If either criterion under para. 27 is not satisfied, the good or service is not distinct. The entity
will then combine the good or service with other promised goods or services until the entity
identifies a bundle of goods or services that are distinct. This could include combining a good
or service that is not considered distinct with another good or service that could be considered
distinct on its own.
Example 3.4: Identifying whether a good or service is distinct

An entity enters into a contract to construct a library for a customer. As part of the contract, the entity is
responsible for providing various goods and services, including engineering, site clearance, material and
labour for the construction of the library, and overall project management services.
Given the entity (or its competitors) can sell many of these goods or services separately to other
customers, it is likely the customer can benefit from the goods or services either on their own or together
with other readily available resources. As such, para. 27(a) of IFRS 15 is met. However, para. 27(b) of
IFRS 15 is not met because the individual goods and services are not distinct. This is because the
entity’s promise to transfer individual goods or services in the contract is not separately identifiable
from other promises in the contract; the entity ‘provides a significant service of integrating the goods
and services’ into a combined output—the library. As such, the goods and services constitute a distinct
bundle of goods and services, and the entity has a single performance obligation to construct the
library as per para. 29 of IFRS 15.
➤➤Question 3.2
A software developer enters into a contract with a customer to transfer a software licence,
provide an installation service, and provide software updates and technical support for a three-
year period. The entity also sells each of these components separately. Although unique to
each customer, the installation service does not significantly modify the software. The software
functions without the updates and the technical support.
Identify the performance obligation(s) within this contract.
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Series of distinct goods and services that are substantially the same and have
the same pattern of transfer
IFRS 15 permits an entity to account for a series of distinct goods or services that are substantially
the same and have the same pattern of transfer as a single performance obligation, provided the
following criteria are met:
• each distinct good or service in the series that the entity promises to transfer to the
customer represents a performance obligation to be satisfied over time (discussed in
‘Step 5: Recognise revenue when each performance obligation is satisfied’)
• the entity uses the same method to measure its progress towards satisfaction of the
performance obligation (discussed in ‘Step 5: Recognise revenue when each performance
obligation is satisfied’) for each distinct good or service in the series (IFRS 15, para. 23).
As stated, these requirements apply to goods or services that are delivered consecutively rather
than concurrently. For example, they would apply to repetitive service contracts such as cleaning
contracts and contracts to deliver utilities such as electricity and gas.
If you wish to explore this topic further you may now re-read para. 22 and read para. 23 of IFRS 15.
Study guide | 211
Step 3: Determine the transaction price of the contract

Determining the total transaction price of a contract is an important part of the five-step model.
This is because once the transaction price is determined, it is allocated among the performance
obligations within the contract (i.e. step 4) and is recognised as revenue when those performance
obligations are satisfied (i.e. step 5).
The transaction price is ‘the amount of consideration to which an entity expects to be entitled
in exchange for transferring promised goods or services to a customer, excluding amounts
collected on behalf of third parties’ (IFRS 15, para. 47). It is the amount to which an entity expects
to be entitled that constitutes the transaction price. As such, it excludes amounts collected on
behalf of another party, such as sales taxes.
The transaction price may be affected by the nature, timing and amount of consideration
promised by a customer. When determining the transaction price, an entity shall consider the
effects of:
• variable consideration, including any constraining estimates of that consideration
• the ‘existence of a significant financing component in the contract’
• non-cash consideration
• consideration that is payable to a customer (IFRS 15, para. 48).
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Variable consideration
The consideration promised in a contract with a customer may include fixed amounts, variable
amounts or both. If the consideration includes a variable amount, an entity ‘shall estimate the
amount of consideration to which [it] will be entitled in exchange for transferring the promised
goods or services to a customer’ (IFRS 15, para. 50).
IFRS 15 specifies examples of when consideration may vary. These include:

• discounts, rebates, refunds, credits and price concessions (whether explicit in the contract
or implied from an entity’s customary business practices, published policies or statements to
the customer) offered to customers, or
• incentives or performance bonuses offered to the entity on the occurrence of a future event,
or penalties imposed on the entity on the occurrence of a future event.
➤➤Question 3.3
Consider whether the following performance payments constitute consideration of a fixed amount,
variable amount or a combination of both and justify your answer:
• A construction company enters into a contract with a customer to build an office block. The
consideration promised by the customer is $1 500 000 with a $350 000 performance bonus
if the office block is completed within 18 months.
• A construction company enters into a contract with a customer to build a warehouse for
$500 000. The contract specifies that the warehouse is to be completed by 30 June 20X6,
and that if it is not completed by 31 August 20X6, the construction company incurs a
$50 000 penalty.
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Estimating variable consideration

An entity shall estimate variable consideration using either the ‘expected value’ or the
‘most likely amount’ method. An entity should choose the method that better predicts the
amount of consideration to which it will be entitled. An entity must apply the chosen method
to that type of variable consideration consistently throughout the contract. An entity is also
required to apply the chosen method consistently to similar types of variable consideration in
other contracts. An entity is, however, permitted to choose different methods for estimating
different types of variable consideration within one contract.
Under the expected value method, the expected value of variable consideration is the sum
of probability-weighted amounts in a range of possible consideration amounts. This method
requires an entity to identify: (1) the possible outcomes of a contract; (2) the probability of each
outcome occurring; and (3) the consideration amount it is entitled to under each outcome.
The sum of each probability-weighted consideration amount the entity is entitled to under
each outcome is the expected value of variable consideration. The expected value method
may better predict variable consideration if the entity has a large number of contracts with
similar characteristics. The IFRS 15 Basis for Conclusions indicates that an entity is not required
to consider all possible outcomes because it may be costly to do so. Rather, a limited number
of discrete outcomes and their probabilities of likelihood can provide a reasonable estimate of
the expected value of variable consideration.
Under the most likely amount method, the expected value of variable consideration is the
consideration amount the entity is entitled to under the ‘most likely’ possible outcome of a
contract. This amount is not probability-weighted. Rather, an entity determines, from a range of
possible outcomes, the outcome that is most likely to occur. The consideration amount the entity
is entitled to under this outcome is the expected value of variable consideration. This method
may be a better predictor of variable consideration than the expected value method if the
contract has only two possible outcomes (e.g. an entity either achieves a performance bonus
or not).
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IFRS 15 states:
An entity shall recognise a refund liability if the entity receives consideration from a customer and
expects to refund some or all of that consideration to the customer. A refund liability is measured
at the amount of consideration received (or receivable) for which the entity does not expect to
be entitled (IFRS 15, para. 55).
This refund liability amount is not included in the transaction price (IFRS 15, para. 55).
If you wish to explore this topic further you may read paras 50–55 of IFRS 15.
Constraining estimates of variable consideration

On estimating the amount of variable consideration within the transaction price, an entity needs
to consider the likelihood that this amount will be realised. Variable consideration that is too
uncertain should not be included in the transaction price. Variable consideration is included in
the transaction price ‘only to the extent that it is highly probable that a significant reversal in the
amount of cumulative revenue recognised will not occur when the uncertainty associated with
the variable consideration is subsequently resolved’ (IFRS 15, para. 56).
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‘Highly probable’ is defined as being ‘significantly more likely than probable’ (as defined in IFRS 5
Non-current Assets held for Sale and Discontinued Operations, Appendix A). A significant reversal
in the amount of cumulative revenue recognised refers to a significant downward adjustment in
the amount of previously recognised revenue. When it is highly probable that a significant reversal
will not subsequently occur, variable consideration is included in the transaction price.
In assessing whether it is highly probable that a significant revenue reversal will not occur in
a subsequent reporting period, an entity should consider both the likelihood and magnitude
of the revenue reversal.
If the entity assesses that it is highly probable that including its variable consideration estimate
will not result in a significant revenue reversal, the amount is included in the transaction
price. This assessment must be done for each performance obligation that contains variable
consideration. Further, the magnitude of a possible revenue reversal should be assessed relative
to the total consideration for each performance obligation. For example, if the consideration
for a single performance obligation includes both a fixed and variable amount, the entity would
assess the magnitude of a possible revenue reversal of the variable amount relative to the total
consideration (i.e. variable plus fixed consideration).
At the end of each reporting period, an entity must update the transaction price to reflect
the amount of consideration to which it expects to be entitled. This includes a reassessment
of whether the variable consideration is constrained and, if so, by what amount. After the
reassessment, if it is highly probable that a significant revenue reversal of all or some of the
variable consideration will occur when the uncertainty associated with the variable consideration
is resolved in future periods, this amount is excluded from the transaction price. This highly
probable and significant reversal of the variable consideration requires a change to the
transaction price and any cumulative revenue recognised.
Similarly, at the end of each reporting period, an entity must adjust the refund liability amount
for changes in expectations about the amount of refunds. The corresponding adjustment
is recognised as revenue (or a decrease in revenue) if the refund liability amount decreases
(or increases).
Example 3.5: E
stimating variable consideration and
determining whether it is included in the
transaction price
An entity enters into a contract with a customer to provide 100 gadgets at a price of $35 per gadget.
Cash is received when control of a gadget transfers. The contract explicitly states that the customer
has the ability to return any unused gadgets within 30 days of transfer and receive a full refund.
As the gadgets are specific to the customer, the entity cannot resell the returned gadgets to another
customer. The contract will be completed before the end of the current reporting period. Based on
past experience, the entity attaches the following probabilities to the estimated number of gadgets
the customer will return:
Gadgets returned Probability of outcome Consideration entitled to

0 10% 100 gadgets × $35 × 10% = $350
1 20% 99 gadgets × $35 × 20% = $693
2 50% 98 gadgets × $35 × 50% = $1715
3 10% 97 gadgets × $35 × 10% = $340
4 10% 96 gadgets × $35 × 10% = $336
Estimated variable consideration (probability-weighted) $3434
Despite having a fixed price ($35 per gadget), the consideration is variable because the contract allows
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the customer to return the gadgets. In estimating the amount of variable consideration, the entity would
use the expected value method. Given there are more than two possible outcomes, the expected
value method better predicts the amount of consideration to which the entity would be entitled in
comparison to the most likely amount method. As shown in the previous table, the expected value
method provides an estimated variable consideration of $3434.
Whether the estimated amount of consideration is included in the transaction price depends on whether
it is highly probable that a significant revenue reversal will occur. Although the returns are outside the
entity’s influence, the entity has significant experience in estimating gadgets likely to be returned by
this customer. Also, the uncertainty will be resolved within a short time frame (i.e. 30 days). As such,
the entity concludes it is highly probable that a significant revenue reversal for the cumulative amount
of revenue recognised (i.e. $3434) will not occur when the uncertainty is resolved (i.e. over the 30-day
return period). Therefore, the transaction price is $3434. On transfer of control of the 100 gadgets,
the entity recognises revenue of $3434 and a refund liability of $66. At the end of the reporting period,
the entity will assess the number of gadgets actually returned and make a corresponding adjustment
to the amount of the refund liability and revenue recognised.
Although the entity would use the expected value method given the circumstances that there are more
than two possible outcomes, the most likely amount method would have produced a similar result.
The most likely outcome is that the customer will return two gadgets, being 50 per cent, which is the
highest probability outcome as shown above. Based on this outcome, the transaction price is $3430
(98 gadgets × $35). On transfer of control of the 100 gadgets, the entity would recognise revenue of
$3430 and a refund liability of $70.
Significant financing component in the contract

The payment of consideration by a customer may not occur at the same time the entity transfers
the good or service to the customer. The consideration may be paid before or after the transfer
occurs. When consideration is paid in advance, the entity receives (from the customer) the benefit
of financing the transfer of the good or service. Alternatively, when consideration is paid in
arrears, the customer receives (from the entity) the benefit of financing the transfer.
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When the benefit of financing is ‘significant’, the contract contains a significant financing
component. When a contract contains a significant financing component, the entity adjusts
the promised amount of consideration (and, therefore, the transaction price of the contract)
for the effects of the time value of money. A significant financing component may exist
irrespective of whether the promise of financing is explicitly stated in the contract or implied
by the payment terms of the contract (IFRS 15, para. 60).
Under IFRS 15, an entity must assess, first, whether a contract contains a financing component
and, second, if it does, whether that component is significant to the contract. This assessment,
however, is not required when the period between the entity transferring a promised good or
service to a customer and the customer paying for the good or service is one year or less. If the
assessment is not required, the financing component (if any) is automatically considered to be
not significant under IFRS 15 (IFRS 15, para. 63).
For those contracts in which the period between the transfer of the good or service and the
payment of consideration is greater than one year, the entity must consider all relevant facts and
circumstances in assessing whether the contract contains a significant financing component.
These facts and circumstances include:
• the difference, if any, between the amount of promised consideration and the price that a
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customer would have paid for the good or service if the customer had paid cash for the good
or service at the time of transfer (i.e. the cash selling price)
• the combined effect of: (1) the ‘expected length of time between when the entity transfers
the promised good or service to the customer and when the customer pays for the good or
service’; and (2) ‘the prevailing interest rates in the relevant market’ (IFRS 15, para. 61).
If the financing component is not considered to be significant, no adjustment is made to the

transaction price of the contract. If the financing component is considered to be significant,
the entity adjusts the amount of the promised consideration for the effects of the time value of
money. This is achieved by discounting the nominal amount of promised consideration to the
cash selling price at the discount rate that would be used if the entity and customer entered into
a separate financing transaction. The discount rate reflects ‘the credit characteristics of the party
receiving financing in the contract’ (IFRS 15, para. 64).
In effect, if a contract contains a significant financing component, the contract conceptually

consists of two transactions: one for the exchange of a good or service and another for the
financing of that good or service. In this case, IFRS 15 requires each transaction to be accounted
for separately. The entity recognises revenue from contracts with customers as the portion of
promised consideration that equals the cash selling price. The entity recognises the difference
between the nominal amount of promised consideration and the cash selling price as interest
revenue (if the entity benefits from financing) or interest expense (if the customer benefits from
financing). Revenue recognised from customers and interest revenue or interest expense shall be
presented separately in the statement of profit or loss and other comprehensive income (P&L and
OCI). ‘Interest revenue or interest expense is recognised only to the extent that a contract asset
(or receivable) or a contract liability is recognised in accounting for a contract with a customer’
If you wish to explore this topic further you may now read paras 60, 61, 63 and 64 of IFRS 15.
Example 3.6: A
ccounting for a significant financing
component in a contract
A property developer enters into a contract with a customer to sell land, with control of the land
transferring to the customer when the contract is signed. The customer has no right to return the
land once the contract is signed. The cash selling price of the land is $50 000, which is the amount
the customer would have paid for the land if payment was required at the time of transfer. Payment,
however, is required 24 months after transfer at an amount of $57 781. The amount of $57 781 is the
promised consideration of the contract.
Given the difference between the amount of promised consideration and the cash selling price
($7781), the length of time between transfer and payment (24 months), and prevailing market interest
rates, the contract includes a significant financing component in accordance with para. 61 of IFRS 15.
The contract includes an implicit interest rate of 7.5 per cent, which the entity considers commensurate
with the rate ‘that would be reflected in a separate financing transaction between the entity and its
customer at contract inception’ (IFRS 15, para. 64).
The entity recognises revenue when control of the land transfers to the customer, as the entity does
not expect to refund some or all of that consideration to the customer (IFRS 15, para. 55). At the time
of transfer, the journal entry would be:
$ $
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Receivable 50 000
Revenue 50 000
As the interest revenue has been recognised as interest receivable over the 24 months, the final journal
entry should be:
$ $
Cash 57 781
Receivable 50 000
Interest receivable 7 781
Non-cash consideration
Customer consideration might be in the form of goods, services or other forms of non-cash
consideration. When a customer promises consideration in a form other than cash, the non-cash
consideration should be measured at fair value according to IFRS 13 Fair Value Measurement and
included in the transaction price. When fair value cannot be reasonably estimated, the non-cash
consideration is measured as the stand-alone selling price of the goods or services promised to
the customer in exchange for the consideration (IFRS 15, paras 66 and 67).
Consideration payable to a customer

Consideration may be payable by entities to their customers:
• in exchange for a distinct good or service that the customer transfers to the entity, or
• as an incentive provided by the entity to the customer to encourage the customer to
purchase a good or service from the entity (e.g. a credit, coupon, voucher, or free product
or service that can be applied against amounts owed to the entity).
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Consideration payable to a customer in exchange for a distinct good or service is accounted for
in the same way that the entity accounts for other purchases from suppliers. However, when the
consideration payable exceeds the fair value of the distinct good or service, the entity accounts
for the excess as a reduction of the transaction price owed to the entity. If the entity cannot
reasonably estimate the fair value of the distinct good or service, all the consideration payable is
accounted for as a reduction of the transaction price owed to the entity. The effect of a reduced
transaction price is a reduction in the revenue ultimately recognised by the entity.
Consideration payable to encourage the customer to purchase a good or service is accounted for
as a reduction of the transaction price owed to the entity. This reduction will reduce the revenue
recognised by the entity from its contract with the customer by the amount of consideration that
is payable to the customer.
Consideration is considered payable to the customer when the recipient of the consideration is
another party that purchased the entity’s goods or services from the customer. For example, a car
manufacturer that offers final consumers 12 months of free car servicing would account for this
as a reduction of the transaction price of the contract with the car dealer that sold the car to the
final consumer.
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Example 3.7: Consideration payable to a customer

An entity that produces breakfast cereals enters into a one-year contract to sell boxes of cereal to a
customer that is a large supermarket chain. The customer commits to buying $5 000 000 worth of cereal
during the year. The contract requires the entity to make a non-refundable payment of $500 000 to
the customer at the inception of the contract to compensate the customer for the changes it needs
to make to its shelving to accommodate the cereal boxes.
The $500 000 payment is not made in exchange for a distinct good or service that the customer transfers
to the entity. As such, in accordance with para. 70 of IFRS 15, the $500 000 payment is a reduction
of the transaction price. The transaction price is therefore $4 500 000, which will be recognised as
revenue on satisfaction of the performance obligation(s) (see ‘Step 4: Allocate the transaction price
to each performance obligation’ and ‘Step 5: Recognise revenue when each performance obligation
is satisfied’).
Step 4: Allocate the transaction price to each performance

obligation
Under this step, the transaction price of the contract (as determined under step 3) is allocated to
each separate performance obligation in the contract (as determined under step 2). For contracts
with a single performance obligation, the allocation process is simple: the entire transaction
price relates to the single performance obligation. It is when the contract contains more than
one performance obligation that the apportionment of the transaction price to each separate
performance obligation is necessary.
Recall that each separate performance obligation in a contract relates to a distinct good or
service. An entity shall allocate the transaction price to each performance obligation based on
the stand-alone selling price of the distinct good or service. To do this, an entity determines the
stand-alone selling price of each distinct good or service underlying each performance obligation
in the contract. Once all stand-alone selling prices have been determined, the entity allocates
the transaction price in proportion to those stand-alone selling prices (IFRS 15, para. 76).
The stand-alone selling price is the price (at the time of entering into the contract) for which an
entity would sell the distinct good or service separately to a customer. The ‘best evidence’ of the
stand-alone selling price is ‘the observable price’ from stand-alone sales of that good or service
to similar customers (IFRS 15, para. 77). If a stand-alone selling price is not directly observable,
entities must estimate that price. IFRS 15 does not preclude or prescribe any particular method
for estimating the stand-alone selling price. The estimation method, however, must provide a
faithful representation of the price at which the entity would sell the distinct good or service
separately to the customer. When estimating a stand-alone selling price:
… an entity shall consider all information (including market conditions, entity-specific factors and
information about the customer or class of customer) that is reasonably available to the entity.
In doing so, an entity should maximise the use of observable inputs and apply estimation methods
consistently in similar circumstances (IFRS 15, para. 78).
Under para. 79 of IFRS 15, the three suitable estimation methods (illustrated in Figure 3.2)
include the following:
• Adjusted market assessment approach: An entity evaluates the market in which it sells
goods or services and estimates the price customers would be willing to pay for those goods
or services, whether provided by the entity or a competitor. Under this approach, an entity
focuses on market conditions, including supply of and customer demand for, the good or
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service; competitor pricing for the same or similar good or service; and the entity’s share of
the market.
• Expected cost plus a margin approach: An entity forecasts its expected costs of satisfying
a performance obligation and then adds an appropriate margin for that good or service.
Under this approach, the entity primarily focuses on entity-specific factors, including its
internal cost structure and pricing strategies and practices.
• Residual approach: An entity estimates the stand-alone selling price as the total transaction
price less the sum of the observable stand-alone selling prices of other goods or services
promised in the contract. Under this approach, when all but one of the stand-alone selling
prices of promised goods or services is directly observable, the stand-alone selling price of
the good or service that is not observable is the difference between the total transaction
price and the sum of directly observable stand-alone selling prices. An entity, however,
may only use the residual approach for a good or service with a highly variable selling price.
Otherwise, the selling price is uncertain because the good or service has not previously been
sold on a stand-alone basis.
Figure 3.2: S
uitable methods for estimating the stand-alone selling price
of a good or service
(a) Suitable methods for estimating the stand-alone selling price of a good or service
Adjusted market Expected cost plus

Residual approach
assessment approach a margin approach
Forecast expected
Estimate the stand-
Evaluate the market costs of satisfying a
alone selling price
performance obligation
Calculate total transaction

Estimate the price Add an price less the sum of
customers would pay appropriate margin the observable stand-
alone selling prices
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(b) Factors that influence the stand-alone selling price estimate under each method
Adjusted market Expected cost plus

Residual approach
assessment approach a margin approach
Market conditions,
Entity-specific factors
supply and demand, High variable
such as internal cost
competitor pricing, selling price
structure and pricing
market share
Allocation of a discount
A discount exists when the sum of the stand-alone selling prices of the distinct goods or
services in the contract exceeds the promised consideration in a contract. Consistent with the
proportionate allocation of the transaction price to each performance obligation in the contract
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(as discussed previously), an entity must allocate a discount proportionately to all performance
obligations in the contract. However, if the entity has observable evidence that the entire
discount relates to one or more, but not all, performance obligations in a contract, it will allocate
the entire discount to those specific performance obligations only (i.e. not to all obligations).
The entity has observable evidence when both of the following criteria are met:
• the entity regularly sells each (or bundles of each) distinct good or service in the contract
on a stand-alone basis and regularly at a discount to the stand-alone selling price
• the discount in the contract is substantially the same as the discount regularly given on
a stand-alone basis.
If you wish to explore this topic further you may read paras 81 and 82 of IFRS 15.
Example 3.8: Allocating a discount

An entity regularly sells scarves, gloves and woollen hats individually, thereby establishing the following
stand-alone selling prices:
$
Scarves 40
Gloves 55
Hats 45
Total 140
In addition, the entity regularly sells gloves and hats together for $60.
The entity enters into a contract with a customer to sell all three products in exchange for $100.
The entity will satisfy the performance obligations of each of the products at different times. The contract
includes a discount of $40 on the overall transaction. Because the entity regularly sells gloves and hats
together for $60 and scarves for $40, it has observable evidence that the entire discount should be
allocated to the promises to transfer the gloves and hats (as per IFRS 15, para. 82).
If the entity transfers control of the gloves and hats at the same time, the entity could account for the
transfer of these products as a single performance obligation. As such, the entity could allocate $60
of the transaction price to the single performance obligation and recognise revenue of $60 when the
gloves and hats simultaneously are transferred to the customer. When the entity transfers control of
the scarves, the entity can allocate $40 of the transaction price to this performance obligation and
recognise revenue of $40 at this time.
If the contract requires the entity to transfer control of the gloves and hats at different times, then the
allocated amount of $60 is allocated to the gloves and hats individually, based on their stand-alone
selling price. The amount of $40 is also allocated to the stand-alone selling price of the scarves.
Allocations are as follows:
Product Allocated transaction price

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

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

customer to the entity on timely delivery of the second good. The bonus constitutes variable
consideration, and it would be inappropriate to allocate it to both performance obligations given
that it relates to the second performance obligation only.
Step 5: Recognise revenue when each performance obligation

is satisfied
Recall that, under step 4, an entity allocates the transaction price of the contract to each
separate performance obligation in the contract. Under step 5, the portion of the transaction
price allocated to a performance obligation is recognised as revenue when (or as) the entity
satisfies that performance obligation. Under IFRS 15, a performance obligation is satisfied when
a promised good or service is transferred to the customer. A good or service is considered to
be transferred when the customer ‘obtains control’ of that good or service (IFRS 15, para. 31).
According to IFRS 15, a good or service is an asset to a customer: the standard states, ‘control
of an asset refers to the ability to direct the use of, and obtain substantially all of the remaining
benefits from, the asset’ (IFRS 15, para. 33). The benefits of an asset are the potential cash inflows
or savings in cash outflows obtained directly or indirectly from the asset.
Transferring control of a promised good or service (and, therefore, concurrently satisfying a

performance obligation) could occur over time or at a point in time. At the time of entering into
a contract, an entity must determine whether it will satisfy the performance obligation over time
or at a point in time. If a performance obligation will not meet the criteria to be satisfied over
time, it is considered to be satisfied at a point in time.
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Performance obligations satisfied over time

A performance obligation is satisfied over time if one of the following criteria is met:
(a) the customer simultaneously receives and consumes the benefits provided by the entity’s
performance as the entity performs;
(b) the entity’s performance creates or enhances an asset that the customer controls as the
asset is created or enhanced; or
(c) the entity’s performance does not create an asset with an alternative use to the entity
and the entity has an enforceable right to payment for performance completed to date
If any of these three criteria are met, the entity transfers control of the good or service over time
while concurrently satisfying the performance obligation. The transaction price allocated to the
performance obligation is recognised as revenue gradually as the performance obligation is
increasingly completed over time. Each criterion will now be examined in turn.
Customer simultaneously receives and consumes the benefits of the entity’s performance
This criterion implies that the entity’s performance creates an asset only momentarily, as the
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asset is simultaneously created, received and consumed by the customer while the entity
performs. As such, this criterion applies only to services and not goods, as a customer cannot
simultaneously receive and consume a good while it is being produced. Not all service-
type performance obligations, however, provide benefits that are simultaneously received
and consumed by the customer while the entity performs. For instance, asset managers are
unlikely to recognise performance fees in full until they are crystallised or no longer subject to
claw-back. In those types of situations, this criterion does not apply.
For some service-type performance obligations, the customer’s receipt and simultaneous
consumption of the benefits of the entity’s performance can be readily identified. Examples
include performance obligations where routine or recurring services are promised, such as
cleaning services or transaction processing services (IFRS 15, para. B3). For other service-type
performance obligations, it may be unclear whether the customer simultaneously receives and
consumes the benefits of the entity’s performance over time. If unclear, the entity will determine
whether another entity would need to substantially re-perform the work it has completed to
date if that other entity were to fulfil the remaining performance obligation to the customer.
If substantial re-performance is not required, the performance obligation is satisfied over time
(IFRS 15, para. B4).
Customer controls the asset as it is being created or enhanced

Under this criterion, control of an asset is transferred over time if the entity’s performance creates
or enhances an asset that a customer controls as the asset is created or enhanced. The meaning
of ‘control’ is the same as that discussed earlier. The asset being created or enhanced can be
either tangible or intangible.
For example, an entity enters into a contract with a single performance obligation: to construct a
building on the customer’s land. In that case, the customer generally controls any work in progress
as the building is constructed. Because the customer controls the work in progress, it is obtaining
benefits of the goods and services the entity is providing. As a result, the performance obligation
is satisfied over time.
Entity’s performance does not create an asset with an alternative use and the entity has
a right to payment for performance completed to date
This criterion has two components: (1) the entity’s performance does not create an asset with
an alternative use to the entity; and (2) the entity has an enforceable right to payment for
performance completed to date. Both components must be present for this criterion to be
met. Each component will now be considered in turn.
Alternative use
When the entity’s performance creates an asset with an alternative use to the entity, the entity
could direct the asset to another customer. The customer does not control the asset as it is
being created because it cannot restrict the entity from directing that asset to another customer.
An example of alternative use is the production of identical inventory items that the entity can
substitute across different contracts with customers.
The entity is less likely to have an alternative use for a highly customised asset that is created for
a customer. The entity would likely need to incur significant costs to rework the asset for another
customer, or need to sell it at a significantly reduced price. As a result, control of the asset could
be considered to be transferred over time (provided the entity also has a right to payment for
performance completed to date).
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Right to payment
Once it has been established that the asset does not have an alternative use to the entity,
the entity must have a right to payment for performance completed to date. An entity has a
right to payment if it is entitled to an amount that compensates it for its performance completed
to date should the customer or another party terminate the contract for reasons other than the
entity’s failure to perform as promised.
Measuring progress on performance obligations satisfied over time

When an entity determines that a performance obligation is satisfied over time (i.e. any of the
three criteria in IFRS 15, para. 35, are met), the entity ’shall recognise revenue over time by
measuring the progress towards complete satisfaction of that performance obligation’ (IFRS 15,
para. 39). An entity applies a single method of measuring progress for each performance
obligation, with the chosen method being the one that best depicts the ‘entity’s performance
in transferring control of goods or services promised to a customer’ (IFRS 15, para. 39). Once the
method has been chosen, an entity cannot change the method of measuring progress, and must
apply it consistently from inception until complete satisfaction of the performance obligation.
IFRS 15 specifies two types of methods of measuring progress on performance obligations

that are satisfied over time: output methods and input methods. In choosing an appropriate
method for measuring progress, an entity must consider the nature of the good or service
that it promised to transfer to the customer (IFRS 15, para. 41). Output methods recognise
revenue based on direct measurements of the value (to the customer) of the goods or services
transferred to date relative to the remaining goods or services promised under the contract.
Examples of output methods include surveying performance completed to date, appraising
results or milestones achieved, determining time elapsed under the contract and measuring
units produced or delivered to date (IFRS 15, para. B15).
Input methods recognise revenue based on the entity’s efforts or inputs towards satisfying
a performance obligation relative to the total expected inputs to satisfy the performance
obligation. Examples of input methods include measuring (to date) resources consumed,
labour hours expended, costs incurred, time elapsed under the contract or machine hours
used (IFRS 15, para. B18).
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Using the chosen output or input method, at the end of each reporting period an entity measures
its progress towards complete satisfaction of a performance obligation satisfied over time.
When an entity is closer to completely satisfying the performance obligation than the previous
period, the change in the measure of progress is recognised as revenue in the current reporting
period. The change in the measure of progress is also disclosed as a change in estimate in
accordance with IAS 8 Accounting Policies, Changes in Accounting Estimates and Errors (IAS 8).
Performance obligations satisfied at a point in time

If none of the three criteria for recognising revenue over time are met, an entity must recognise
revenue at a point in time. The time to recognise revenue is when the entity transfers control of
the asset to the customer. The meaning of ‘control’ is the same as that discussed earlier. At the
time control is transferred, the performance obligation is satisfied.
If you wish to explore this topic further you may now read para. 38 of IFRS 15.
Example 3.9: D
etermining whether a performance obligation
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is satisfied over time or at a point in time
An entity enters into a contract with a customer to provide a consulting service on how to improve
production process efficiency and, on completing the consultation, a final recommendation.
The consulting service with final recommendation constitutes a single performance obligation.
The customer benefits from the entity’s performance once complete and the final recommendation is
made; benefit does not occur while the entity performs. As such, the customer does not simultaneously
receive and consume the benefits provided by the entity’s performance as the entity performs,
per para. 35(a) of IFRS 15. As this criterion is not satisfied, the performance obligation is not satisfied
over time but, rather, at a point in time. The entity recognises revenue on completing the consultation.
Contract costs
In certain instances, IFRS 15 permits an entity to recognise the following as assets:
1. the incremental costs of obtaining a contract with a customer
2. the costs to fulfil a contract with a customer.
Each of these types of contract costs will now be considered in turn.
Incremental costs of obtaining a contract

Under para. 91 of IFRS 15, the incremental costs of obtaining a contract shall be recognised as
an asset if the entity expects to recover those costs. There are two aspects to this recognition
requirement. First, the costs of obtaining a contract are ‘incremental’, and, second, the entity
expects to recover these costs. Costs of obtaining a contract are incremental if they would not
have been incurred had the contract not been obtained (IFRS 15, para. 92), while recovery of
these costs may be either direct (i.e. reimbursement by the customer under the terms of the
contract) or indirect (i.e. incorporated into the profit margin of the contract). Costs of obtaining
a contract that are not incremental (i.e. costs incurred regardless of whether the contract was
obtained) are recognised as an expense when incurred, unless they are chargeable to the
customer regardless of whether the contract is obtained (IFRS 15, para. 93).
For expediency, IFRS 15 permits an entity to recognise the incremental costs of obtaining a
contract as an expense when those costs are incurred, even though they would otherwise qualify
for asset recognition if the asset’s amortisation period is up to one year (IFRS 15, para. 94).
➤➤Question 3.4
A consulting services entity wins a tender process to provide consulting services to a new
customer. The contract is for two years with an option for the entity to extend the contract for
another year. The entity intends on exercising this option. The entity incurs the following costs
to obtain the contract:
$
Legal fees to lodge tender 25 000
Travel costs to deliver proposal 20 000
Sales commission to employees for obtaining the contract 12 500
Total costs incurred 57 500
As part of the agreement with the lawyer involved in preparing the tender, $10 000 is payable
regardless of whether the tender is successful. The remaining $15 000 in legal fees becomes
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payable on the success of the tender. All legal fees are borne by the entity and not recoverable
from the customer. What amount should the entity recognise as an asset for the incremental
costs of obtaining the contract?
in 2017 IFRS Standards, IFRS Foundation, London, p. B1766.
Costs to fulfil a contract

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

Under IFRS 15, an asset recognised from the incremental costs of obtaining a contract or from
the costs to fulfil a contract is subject to amortisation and impairment. Amortisation shall occur
‘on a systematic basis that is consistent with the transfer to the customer of the goods or services
to which the asset relates’ (IFRS 15, para. 99). Generally speaking, unless the asset relates to a
particular performance obligation within the contract, the amortisation period will be the life of
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the contract. When there is a significant change in the entity’s expected timing of transfer to the
customer of the goods or services to which the asset relates, the entity updates the amortisation
to reflect the change. This may arise, for example, if the entity renews a contract for an additional
period that was not anticipated at contract inception. This type of change is accounted for as a
change in accounting estimate under IAS 8 (IFRS 15, para. 100).
An entity recognises an impairment loss to the extent that the carrying amount of the asset that
is recognised exceeds ‘the remaining amount of consideration that the entity expects to receive
in exchange for the goods or services to which the asset relates’, less the yet-to-be-incurred costs
‘that relate directly to providing those goods or services’ (IFRS 15, para. 101). When an entity
determines the amount of consideration it expects to receive, the principles for determining the
transaction price are to be used (see ’Step 3: Determine the transaction price of the contract’).
Example 3.10: D
etermining the amortisation period of an
asset recognised for contract costs
Based on the information provided in Question 3.4, the amortisation period for the asset recognised
is three years. This is consistent with the transfer of services to the customer to which the asset relates,
as the entity intends on extending the contract at contract inception. Given the asset amount ($12 500)
and amortisation period (three years), amortisation is $4167 per year.
If the entity does not exercise the option to extend the contract at the end of the second year,
the remaining unamortised amount will be amortised immediately and accounted for as a change in
accounting estimate under IAS 8.
Disclosure
As discussed in the Introduction, it has been argued that disclosures made by entities under
existing IFRSs in relation to revenue are inadequate for financial statement users to understand
the entity’s revenue recognition practices. Entities’ revenue-related disclosures have been
criticised for being generic or boilerplate in nature, in that they provide little information that
is useful to users, including insufficient explanations of the judgments and estimates made in
recognising that revenue or the relationship between the revenue recognised and other financial
statement information.
To overcome these deficiencies, the objective of the IFRS 15 disclosure requirements is:
… for an entity to disclose sufficient information to enable users of financial statements to
understand the nature, amount, timing and uncertainty of revenue and cash flows arising from
contracts with customers (IFRS 15, para. 110).
To achieve this objective, IFRS 15 requires an entity to disclose qualitative and quantitative
information about all of the following:
• its contracts with customers
• the significant judgments, and changes in judgments, made in applying IFRS 15 to
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those contracts
• any assets recognised from the incremental costs of obtaining a contract or the costs
to fulfil a contract.
Each of these disclosure requirements is now examined in turn.
Contracts with customers

The majority of the disclosures required under IFRS 15 relate to an entity’s contracts with
customers. In relation to contracts with customers, an entity must disclose disaggregated
revenue from contracts with customers, contract balances, performance obligations and the
transaction price allocated to remaining performance obligations.
Disaggregation of revenue
Under IFRS 15, an entity must disclose revenue recognised from contracts with customers
that has been disaggregated into categories that depict how the nature, amount, timing,
and uncertainty of revenue and cash flows are affected by economic factors (IFRS 15, para. 114).
IFRS 15 provides guidance on how entities might disaggregate revenue for financial statement
users to assist users in understanding the composition of revenue from contracts with customers
that is recognised in the current period. This guidance includes the following examples
of categories:
(a) type of good or service ([e.g.] major product lines);
(b) geographical region (for example, country or region);
(c) market or type of customer (for example, government and non-government customers);
(d) type of contract (for example, fixed-price and time-and-materials contracts);
(e) contract duration (for example, short-term and long-term contracts);
(f) timing of transfer of goods or services (for example, revenue from goods or services transferred
to customers at a point in time and revenue from goods or services transferred over time); and
(g) sales channels (for example, goods sold directly to consumers and goods sold through
intermediaries) (IFRS 15, para. B89).
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Contract balances
In relation to contract balances, an entity must disclose all of the following:
• the opening and closing balances of receivables, contract assets and contract liabilities from
contracts with customers
• revenue recognised in the reporting period that was included in the contract liabilities
opening balance
• revenue recognised in the reporting period from performance obligations that were either
completely or partially satisfied in previous periods (IFRS 15, para. 116).
A contract liability arises when an entity has received consideration (or has an unconditional
right to receive consideration from the customer before the entity transfers a good or service
to the customer. It is the obligation to transfer the good or service that is a contract liability.
The unconditional right to receive compensation from a customer constitutes a receivable.
Further, ‘[a] right to consideration is unconditional if only the passage of time is required before
payment of that consideration is due’ (IFRS 15, para. 108). This is distinct from a contract asset,
which is ‘[a]n entity’s right to consideration in exchange for goods or services that the entity
has transferred to a customer when that right is conditioned on something other than the
passage of time ([e.g.] the entity’s future performance)’ (IFRS 15, Appendix A). IFRS 15 makes
the distinction between receivables and contract assets to enable users to differentiate between
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an unconditional and conditional right to receive consideration.
Disclosures about an entity’s contract balances help users understand the relationship between
the revenue recognised and changes in the balances of an entity’s contract assets and liabilities
during a reporting period (IFRS 15 Basis for Conclusions, para. BC341). For example, disclosing the
opening balances of contract liabilities will help users understand the amount of revenue that
will be recognised during the current period, while disclosing the opening balances of contract
assets will provide them with an understanding of the amounts that will be transferred to accounts
receivable or collected as cash during the period (IFRS 15 Basis for Conclusions, para. BC343).
Performance obligations
In relation to performance obligations, an entity must disclose a description of all of the following:
• ‘when the entity typically satisfies its performance obligations’ (e.g. on shipment, on delivery,
as services are rendered or when they are completed)
• ‘the significant payment terms’ (e.g. when payment is due, and if the contract includes a
significant financing component, the amount of consideration is variable or its estimate
is constrained)
• ‘the nature of the goods or services that the entity has promised to transfer’
• ‘obligations for returns, refunds and other similar obligations’
• ‘types of warranties and related obligations’ (IFRS 15, para. 119).
Transaction price allocated to remaining performance obligations

The final disclosure requirement related to contracts with customers requires an entity to disclose
the amount of the transaction price that is allocated to the unsatisfied performance obligations
in a contract (whether partial or complete) at the end of the reporting period. An entity must also
provide an explanation of when it expects to recognise as revenue the transaction price amount
allocated to the unsatisfied performance obligations. This explanation can be either quantitative
(e.g. amounts to be recognised as revenue according to specified time bands) or qualitative
(IFRS 15, para. 120).
These disclosure requirements provide users with information about the amount and timing of
revenue that an entity expects to recognise from the remaining performance obligations in its
existing contracts with customers (IFRS 15 Basis for Conclusions, para. BC350).
Example 3.11: D
isclosure of the transaction price allocated
to remaining performance obligations
On 30 June 20X6, an entity enters into a three-year contract with a customer to provide office
maintenance services. The services are to be provided as and when needed, capped at a maximum of
two visits per month over the next three years. The customer pays a fixed amount of $300 per month
for the services. The transaction price of the contract is $10 800. The performance obligation under the
contract is satisfied over time, and the entity uses a time-based output method in measuring progress
towards complete satisfaction of the performance obligation.
In accordance with para. 120 of IFRS 15, the entity is required to disclose at the end of each reporting
period the amount of the transaction price allocated to the unsatisfied performance obligation, which is
yet to be recognised as revenue. The entity chooses to explain when it expects to recognise the amount
as revenue using quantitative time bands. As such, for the reporting period ending 31 December 20X6,
the following information is disclosed:
20X7 20X8 20X9 Total

$ $ $ $
Revenue expected to be recognised on 3600 † 3600
†
1800 ‡
9000
this contract as of 31 December 20X6
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†
$300 per month × 12 months
‡
$300 per month × 6 months
Significant judgments in the application of IFRS 15 Revenue from

Contracts with Customers
An entity is required to disclose and explain the judgments and changes in judgments used to
determine the:
• timing of satisfaction of performance obligations
• transaction price and amounts allocated to performance obligations (IFRS 15, para. 123).
Disclosure of the estimates and judgments made by an entity in determining the transaction
price, allocating the transaction price to performance obligations, and determining when
performance obligations are satisfied allows users to assess the quality of earnings reported
by the entity.
Assets recognised from contract costs

In relation to assets recognised from the costs to obtain or fulfil a contract with a customer,
an entity must:
• provide a description of the judgments made in determining the amount of the costs,
and of the amortisation method used for each reporting period
• disclose the closing balances of the assets recognised
• disclose the amount of amortisation and any impairment losses recognised in the reporting
period (IFRS 15, paras 127 and 128).
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Summary
This part focused on accounting for revenue from contracts with customers under IFRS 15.
Previous revenue standards have been criticised for a lack of comparability in the revenue
recognition practices being used by entities and the disclosure of insufficient revenue-related
information. A consequence of these shortcomings has been that financial statement users
have been unable to make consistent and accurate assessments about entities’ revenue-
earning activities.
As a key indicator of an entity’s, and management’s, performance is the revenue it generates,

it is important for users and preparers of financial statements to have an understanding of how
revenue is to be measured and recognised in the entity’s financial statements. By introducing a
five-step model of revenue recognition capable of general application to a variety of transactions
and by requiring more detailed revenue-related disclosures, IFRS 15 enhances the financial
reporting of revenue.
IFRS 15 establishes principles for reporting useful information to financial statement users about
the nature, amount, timing and uncertainty of revenue and cash flows from an entity’s contracts
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with customers. These principles provide a framework of broad revenue recognition concepts
that can be consistently applied across entities and encourage providing information to users so
that they can make informed assessments of entities’ performance relative to other entities.
Part B: Provisions
Introduction
Part B reviews issues relating to the recognition, measurement and disclosure of provisions,
including the requirements of IAS 37 Provisions, Contingent Liabilities and Contingent Assets
(IAS 37). IAS 37 outlines specific existence, recognition and measurement criteria to be applied
to provisions; it also requires extensive disclosures. The recognition of provisions, and the
disclosure of information about their nature and the timing, amount and likelihood of any
resulting outflows, provides financial statement users with a more complete understanding
of an entity’s existing obligations. However, opportunities exist for managers to exploit the
uncertainty and subjectivity of provisions when recognising and measuring them, in order to
manipulate reported accounting numbers.
This part begins with the definition of a provision, followed by a discussion on key aspects of
the recognition of provisions. Measurement issues are then discussed, including how to deal with
risks and uncertainties, as well as the use of probability in measurement. Part B concludes with a
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discussion on disclosure requirements relating to provisions.
Scope of IAS 37 Provisions, Contingent Liabilities and

Contingent Assets
IAS 37 applies to all provisions (and to contingent liabilities and contingent assets discussed
in Part C) other than those that:
• result from executory contracts, except for onerous contracts
• are covered by another standard (IAS 37, para. 1).
Executory contracts are ‘contracts under which neither party has performed any of its obligations
or both parties have partially performed their obligations to an equal extent’ (IAS 37, para. 3).
Importantly, IAS 37 does not apply to financial instruments (including guarantees) that are within
the scope of IFRS 9 Financial Instruments. Financial instruments are covered in Module 6.
Other provisions, contingent liabilities and contingent assets that are covered by other
standards are:
• income taxes (IAS 12 Income Taxes)
• leases (IFRS 16 Leases), except any lease that becomes onerous before its commencement
date, or short-term leases and leases where the underlying asset is of low value and that
the lease has become onerous
• employee benefits (IAS 19 Employee Benefits)
• insurance contracts within the scope of IFRS 4 (IAS 37, para. 5).
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Definition of provisions
Provisions are a subset of liabilities; therefore, to properly understand provisions it is helpful
to revisit the definition of a liability. The IASB Conceptual Framework for Financial Reporting
(Conceptual Framework) defines a liability as:
… a present obligation of the entity arising from past events, the settlement of which is expected
to result in an outflow from the entity of resources embodying economic benefits (Conceptual
Framework, para. 4.4(b)).
Provisions are defined in IAS 37 as ‘liabilities of uncertain timing or amount’ (IAS 37, para. 10).
A key aspect of this definition is the requirement that uncertainty exists. However, not all
uncertainties give rise to a provision. An estimate of timing or amount does not automatically
result in uncertainty. For example, estimates used to determine the depreciation of property,
plant and equipment over the period of use do not make depreciation a provision. The precise
pattern in which economic benefits are consumed may be uncertain, but the fact that economic
benefits of the asset will eventually be consumed is not uncertain.
When there is a significant level of certainty (i.e. an insignificant level of uncertainty), the amount
is not recognised as a provision, but as a liability. Examples of these types of liabilities are
borrowings, trade creditors and accruals.
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In cases where the degree of uncertainty in relation to the timing or amount of the liability
cannot be measured with sufficient reliability, the amount is classified as a contingent liability
(discussed in Part C of this module).
➤➤Question 3.5
With reference to the scope of IAS 37 and the definition of a provision, identify which of the
following is likely to be a provision within the scope of IAS 37, and which is likely to be another
form of liability and explain why.
• An obligation to repair or replace goods sold if they are determined to be faulty
• A warranty provided for a television sold by a retailer

• Annual leave
Recognition of provisions
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The Conceptual Framework criteria for the recognition of liabilities state that a liability should
be recognised when:
… it is probable that an outflow of resources embodying economic benefits will result from the
settlement of a present obligation and the amount at which the settlement will take place can be
measured reliably (Conceptual Framework, para. 4.38).
Consistent with this requirement, IAS 37 requires the following conditions to be met for a
provision to be recognised:
(a) an entity has a present obligation (legal or constructive) as a result of a past event;
(b) it is probable that an outflow of resources embodying economic benefits will be required
to settle the obligation; and
(c) a reliable estimate can be made of the amount of the obligation (IAS 37, para. 14).
Present obligation and past event

The first recognition criterion in para. 14 of IAS 37 requires the entity to have a present obligation
‘as a result of a past event’. The importance of this recognition criterion was outlined by the
G4+1 Group of accounting standard setters:
If the trigger point for recognition is set too early, the result would be to recognise a liability and an
expense where none exist, thus reducing the relevance and reliability of the financial statements.
A provision could be recognised for expenditures that, in the event, are never made. The effect
would be to misstate both the entity’s financial position (by recording a liability that does not
actually exist) and its financial performance (by recognising an expense in one accounting period
and income in another in relation to amounts that are never actually paid or received).
Conversely, it would be incorrect not to provide for expenditures that are clearly unavoidable,
result from past events, and are measurable with a high degree of reliability simply on the grounds
that the outflow of cash or other resources will not occur until a future date. Failure to recognise
a provision in such circumstances would result in the financial statements not portraying faithfully
either the expenses incurred in the accounting period or the liabilities of the entity at the statement
of financial position date.
Source: Lennard, A. & Thompson, S. 1995, Provisions: Their Recognition, Measurement and Disclosure
in Financial Statements, Financial Accounting Standards Board, Norwalk, paras 2.1.5–6. © Financial
Accounting Foundation, 401 Merritt 7, Norwalk, CT 06856, USA. Reproduced with permission.
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The standard setters believed that it will normally be clear whether a past event has given rise to
a present obligation that should be recognised in the statement of financial position. However,
in rare cases it may not be clear whether a present obligation exists. In such cases, IAS 37
provides the following guidance:
[A] past event is deemed to give rise to a present obligation if, taking account of all available
evidence, it is more likely than not that a present obligation exists at the end of the reporting
period (IAS 37, para. 15).
Such evidence is not limited only to what is available at the closing date of the financial
statements; it specifically includes information from events that may occur between the end
of the reporting period and the time of completion of the financial report.
The Conceptual Framework notes that an obligation ‘is a duty or responsibility to act or perform
in a certain way. Obligations may be legally enforceable as a consequence of a binding contract
or statutory requirement’ (Conceptual Framework, para. 4.15). The obligation must involve
another party to whom the obligation is owed—that is, a third party. For a present obligation
to exist, the entity must have no realistic alternative to settling the obligation created by the
event (IAS 37, para. 17).
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The most common form of present obligation is a legal obligation, in which an external party has
a present legal right to force the entity to pay or perform. However, it may also be a constructive
obligation to the extent that there is a valid expectation in other parties that the entity will
discharge the obligation. Consistent with the Conceptual Framework definition of a liability,
a constructive obligation is defined in IAS 37 as:
… an obligation that derives from an entity’s actions where:
(a) by an established pattern of past practice, published policies or a sufficiently specific
current statement, the entity has indicated to other parties that it will accept certain
responsibilities; and
(b) as a result, the entity has created a valid expectation on the part of those other parties
that it will discharge those responsibilities (IAS 37, para. 10).
By including constructive obligations as a form of present obligation, the Conceptual Framework

extends the definition of liabilities beyond the issue of legal enforceability. The definition
includes liabilities arising from normal business practice or custom, a desire to maintain good
business relations or a desire to act in an equitable manner (e.g. habitually providing staff with
bonus payments or performing environmental remediation to a standard higher than that
required by law), but not from a contractual agreement with another entity.
If you wish to explore this topic further you may now read paras 15–22 of IAS 37, as well as the
implementation guidance: ‘Guidance on Implementing IAS 37’, C. Examples: recognition, Example 2B
‘Contaminated land and constructive obligation’ in Part B of the Red Book 2017.
Probable outflow of economic benefits

The second criterion in para. 14 of IAS 37 for the recognition of provisions is that ‘it is probable
that an outflow of resources embodying economic benefits will be required to settle the
obligation’. This occurs when the outflow of resources or another event is more likely than not
to occur. That is, the probability that the event will occur is greater than the probability that it
will not (IAS 37, para. 23). Where there are a number of similar obligations, such as warranty
obligations arising from product sales, the class of obligations is considered as a whole in
determining whether an outflow of resources is probable (IAS 37, para. 24).
Reliable measurement
The third recognition criterion in para. 14 of IAS 37 is that ‘a reliable estimate can be made
of the amount of the obligation’. IAS 37 notes that:
… except in extremely rare cases, an entity will be able to determine a range of possible
outcomes and can therefore make an estimate of the obligation that is sufficiently reliable to
use in recognising a provision (IAS 37, para. 25).
Consequently, a provision is considered to be capable of being reliably measured even if a

number of possible outcomes exist.
The use of reasonable estimates is an essential part of the preparation of financial statements
and does not undermine the reliability of the statements (Conceptual Framework, para. 4.41).
➤➤Question 3.6
A manufacturer gives warranties at the time of sale to purchasers of its product. Under the
terms of the contract for sale, the manufacturer undertakes to remedy, by repair or replacement,
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manufacturing defects that become apparent within three years from the date of sale. As this
is the first year that the warranty has been available, there is no data from the firm to indicate
whether there will be claims under the warranties. However, industry research suggests that it
is likely that such claims will be forthcoming.
Should the manufacturer recognise a provision in accordance with the requirements of IAS 37?
Why or why not?
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Measurement of provisions
One of the more difficult aspects of accounting for provisions is determining the amount to be
recognised in the financial statements given the inherent uncertainty surrounding provisions.
As the actual amount of sacrifice of economic resources is often not known with certainty
(by definition), estimates of the provisions are required to be made.
IAS 37 requires that:

… the amount recognised as a provision shall be the best estimate of the expenditure required
to settle the present obligation at the end of the reporting period (IAS 37, para. 36).
The best estimate is the amount that an entity would rationally pay either to settle the obligation
at that date or to transfer it to a third party at that time. The estimation requirements differ
depending on whether the provision involves a large population of items or a single obligation,
and are outlined in IAS 37 as follows:
• ‘Where the provision being measured involves a large population of items, the obligation is
estimated by weighting all possible outcomes by their associated probabilities. The name for
this statistical method of estimation is “expected value”’ (IAS 37, para. 39).
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• ‘Where a single obligation is being measured, the individual most likely outcome may be the
best estimate of the liability’ (IAS 37, para. 40).
With regard to determining best estimates, IAS 37 suggests that the most appropriate estimate
of the provision is determined by using:
… the judgement of the management of the entity, supplemented by experience of similar
transactions and, in some cases, reports from independent experts. The evidence considered
includes any additional evidence provided by events after the reporting period (IAS 37, para. 38).
IAS 37 states that ‘where there is a continuous range of possible outcomes, and each point in
that range is as likely as any other, the mid-point of the range is used’ (IAS 37, para. 39).
These criteria are consistent with the enhancing qualitative characteristic of verifiability. As noted
in para. QC26 of the Conceptual Framework, quantified information need not be a single point
estimate to be verifiable. A range of possible amounts and the related probabilities can also
be verified.
Example 3.12: Calculation of best estimate

Part A
An entity faces 100 warranty claims relating to a faulty widget. The entity’s management has determined
there is a 30 per cent likelihood that each of these claims is unsubstantiated and will not cost the entity
anything. There is a 70 per cent likelihood that the cost of each claim will be $100.
According to the expected value method, the best estimate of the provision can be calculated as
70% × 100 × $100 = $7000.
Part B
Now assume that the same entity is facing a single warranty claim with the same probabilities as in
Part A. In such circumstances, IAS 37 requires the individual most likely outcome be used to calculate
the amount of the provision. In this example, the most likely outcome is that $100 will be paid to settle
the warranty claim. As such, the cost of $100 is the most likely outcome because it has a 70 per cent
chance of occurring, whereas there is a 30 per cent chance of no payout being required.
Therefore, $100 would be the amount required to be recognised in accordance with IAS 37.
Discounting
Example 3.12 ignored the effect of discounting. However, IAS 37 requires that:
… where the effect of the time value of money is material, the amount of a provision shall
be the present value of the expenditures expected to be required to settle the obligation
(IAS 37, para. 45).
Consequently, provisions are discounted when the effect of this discounting is material.
The discount rate should be a pre-tax rate that reflects current market assessments of the
time value of money and the risks specific to the liability. The discount rate must not reflect
risks for which the future cash flow estimates have been adjusted (IAS 37, para. 47).
IAS 37 also notes that risks and uncertainties should be taken into account in reaching the best
estimate of a provision. It cautions, however, that ‘uncertainty does not justify the creation of
excessive provisions or a deliberate overstatement of liabilities’ (IAS 37, para. 43).
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➤➤Question 3.7
Refer to the background material in Question 3.6.
The firm has now been operating its warranty for five years, and reliable data exists to suggest
the following:
• If minor defects occur in all products sold, repair costs of $2 million would result.
• If major defects are detected in all products, costs of $5 million would result.
• The manufacturer’s past experience and future expectations indicate that each year
80 per cent of the goods sold will have no defects, 15 per cent of the goods sold will have
minor defects, and 5 per cent of the goods sold will have major defects.
Calculate the expected value of the cost of repairs in accordance with the requirements of IAS 37.
Ignore both income tax and the effect of discounting.
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IAS 37—Provisions, Contingent Liabilities

and Contingent Assets: Disclosure
Provisions
IAS 37 includes a number of disclosure requirements relating to provisions, which assist financial
statement users to understand the reasons, uncertainty and subjectivity behind the recognised
end of period carrying amount. As discussed in greater detail shortly, subjectivity in recognising
and measuring provisions makes them a potential tool for entities to manage their earnings,
where earnings management is the manipulation of revenue and expense to smooth out profit
fluctuations or to achieve a predetermined (and often an overstated) profit result. The disclosure
requirements of IAS 37 aim to reduce the ability of entities to use provisions as a means of earnings
management. The key disclosures required by IAS 37 relating to provisions are outlined as follows:
For each class of provision, an entity shall disclose:
(a) the carrying amount at the beginning and end of the period;
(b) additional provisions made in the period, including increases to existing provisions;
(c) amounts used (i.e. incurred and charged against the provision) during the period;
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(d) unused amounts reversed during the period; and
(e) the increase during the period in the discounted amount arising from the passage of time
and the effect of any change in the discount rate.
Comparative information is not required.
An entity shall disclose the following for each class of provision:
(a) a brief description of the nature of the obligation and the expected timing of any resulting
outflows of economic benefits;
(b) an indication of the uncertainties about the amount or timing of those outflows.
Where necessary to provide adequate information, an entity shall disclose the major
assumptions made concerning future events, as addressed in paragraph 48; and
(c) the amount of any expected reimbursement, stating the amount of any asset that has
been recognised for that expected reimbursement (IAS 37, paras 84 and 85).
The requirements of para. 84 of IAS 37 are illustrated in Note 15 of the Techworks Ltd
To explore this topic further, read Note 15—‘Provisions’, in the Techworks Ltd financial statements
provided in the appendix to the Study guide, and also available on My Online Learning.
➤➤Question 3.8
Review Note 15 ‘Provisions’ of the Techworks Ltd financial statements. Focusing on the Provision
for warranties class of provisions, highlight how Techworks Ltd has complied with the requirements
of para. 85 of IAS 37 in this disclosure.
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➤➤Question 3.9
Consider the following quote:
At present, banks create provisions to meet the costs of … restructuring. When analysts
analyse these, they classify them as significant items so that they appear below the
operating profit line; this ensures the cost of these provisions disappears from their
calculations of the operating profit. By over-provisioning with below-the-line significant
items in a good year, the company can use the over-provisions during a bad year when
there are additional write-offs. The write-offs do not appear in the operating profit
(Washington 2002, p. 74).
Explain how the disclosure requirements contained in IAS 37 reduce the ability of entities to engage
in earnings management through the increase and then subsequent write-back of provisions.
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Exemptions
Although the disclosure requirements of IAS 37 are more extensive than many entities would
like, the standard does provide some relief from compliance with the requirements. This relief
includes when:
… disclosure of some or all of the information required … can be expected to prejudice seriously
the position of the entity in a dispute with other parties on the subject matter of the provision,
contingent liability or contingent asset (IAS 37, para. 92).
IAS 37 notes that this exemption would occur only in extremely rare cases and, therefore,
cannot be used to circumvent the disclosure requirements. Also, even when the exemption
is applicable, the general nature of the dispute, together with the fact and reason why that
information has not been disclosed, must be stated.
If you wish to explore this topic further you may now read para. 92 of IAS 37.
Provisions and professional judgment
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An entity’s accountant is required to exercise professional judgment in determining whether
an obligation constitutes a provision. If it is a provision, professional judgment is also required
in measuring the provision. The need for professional judgment introduces discretion and
subjectivity into financial reporting, which creates potential pressures from management
for the accountant to manipulate reported accounting numbers, including engaging in
earnings management.
For example, a distinguishing feature between provisions and other types of liabilities,
such as trade payables, is the degree of uncertainty in the timing or amount of the obligation.
Recall that it is when the level of uncertainty is significant that the obligation is recognised as a
provision. When deciding on the degree of uncertainty, an accountant is required to exercise
professional judgment.
Professional judgment is also required in the measurement of provisions. Recall that IAS 37 states
that the best estimate is to be used to measure provisions. The best estimate includes the use
of either the ‘expected value’ method or the ‘most likely outcome’ method. The inputs used to
derive the best estimate under either method, namely the likelihood of an outcome or outcomes
occurring, are often subject to the discretion of an entity’s management. Management may
exploit this discretion to understate provisions, and thereby reduce the entity’s total liabilities.
An accountant must exercise professional judgment in ensuring that these inputs can be verified.
Example 3.13: Discretion in the calculation of best estimate

Continuing on from Example 3.12, now assume that management has revised its estimates so that
there is a 45 per cent likelihood that each of the warranty claims is unsubstantiated and a 55 per cent
likelihood that the cost of each claim will be $100.
According to the expected value method, the best estimate of the provision is now $5500 (55% × 100 ×
$100 = $5500), which is $1500 lower compared with the original estimate in Example 3.12.
The use of professional judgment in recognising and measuring provisions not only enables
manipulation of reported liabilities in the statement of financial position, but also creates
opportunities for earnings management. This is because the understatement of provisions
also results in an understatement of the corresponding expense, and in so doing overstates
reported profit for the current period. Using Example 3.13 to illustrate this, both the warranty
provision and warranty expense would be $1500 lower compared with their original amounts in
Example 3.12 due to management’s revised estimates. Exercising discretion in the recognition
and measurement of provisions, therefore, simultaneously affects an entity’s reported financial
position and its profit.
Summary
This part focused on accounting for provisions under IAS 37.
IAS 37 outlines specific criteria to be applied to provisions in their recognition and measurement,
and requires extensive disclosures. The recognition of provisions provides financial statement
users with an understanding of the entity’s existing obligations. The disclosure of information
about the nature of provisions and the timing, amount and likelihood of any resulting outflows
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assists users to understand the reasons, uncertainty and subjectivity behind the recognised end
of period carrying amount. It is the presence of this uncertainty and subjectivity that enables
managers to manipulate reported accounting numbers. The discretion exercised in measuring
provisions creates opportunities for managers to understate provisions in the statement
of financial position and the corresponding expense, thereby, overstating reported profit.
While the measurement of provisions is subject to an entity’s accountant verifying the accuracy
of management’s estimates, financial statement users should be mindful of subjectivity in the
measurement of provisions.
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Part C: Contingent liabilities and

contingent assets
Introduction
Part C reviews the requirements of IAS 37 in relation to contingent liabilities and contingent
assets. The objective of the standard is to assist users in assessing the nature and amount of
contingent assets and contingent liabilities, as well as the uncertainties that are expected to
affect their outcomes. The standard’s ultimate aim is to ensure consistent reporting practices,
even though recognition of contingent liabilities and contingent assets is prohibited in the
financial statements and note disclosure is generally required.
Contingent assets
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Recognition of assets
The guidance related to the recognition and disclosure of assets in the Conceptual Framework
(para. 4.4) provides a foundation for considering issues of contingent assets. The Conceptual
Framework defines assets as:
… a resource controlled by the entity as a result of past events and from which future economic
benefits are expected to flow to the entity (Conceptual Framework, para. 4.4(a)).
The notion of future economic benefit is the essence of an asset. Other properties of assets,
such as exchangeability, are indicative but not essential characteristics, as future economic
benefits can be gained from the use of assets, even though they may have no disposal value.
In relation to assets, control refers to the capacity of the entity either to benefit from the asset
in pursuing its objectives, or to deny or regulate others’ access to that benefit. Ownership of a
resource is not necessary for an asset to exist.
Should an item comply with the definition above, an asset exists. However, for it to be reported
in the entity’s statement of financial position, two recognition hurdles must be overcome.
First, it must be ‘probable that the future economic benefits will flow to the entity’, and second,
the asset must possess ‘a cost or value that can be measured reliably’ (Conceptual Framework,
para. 4.44).
‘Probable’ is generally described as meaning more likely than not, or more than 50 per cent.
This is the generally accepted interpretation of the meaning of the term ‘probable’. In relation
to the recognition criterion of ‘reliable measurement’, the assets must be faithfully represented.
‘Faithful representation’ means information that is complete, neutral and free from error.
Paragraph QC15 of the Conceptual Framework notes that ‘faithful representation’ does not
mean information that is ‘accurate in all respects’. In the context of estimates, a representation
of an estimate (as is the case for provisions) can be faithful if:
… the amount is described clearly and accurately as being an estimate, the nature and limitations
of the estimating process are explained, and no errors have been made in selecting and applying
an appropriate process for developing the estimate (Conceptual Framework, para. QC15).
It should also be noted that an item that, at a particular time, fails to meet the recognition criteria
in para. 4.38 of the Conceptual Framework may qualify for recognition at a later date as a result
of subsequent circumstances or events (Conceptual Framework, para. 4.42).
Contingent assets
The definition of contingent assets in IAS 37 is based on the definition of assets provided in the
Conceptual Framework. However, the definition overcomes some of the difficulties associated
with the recognition criteria.
A contingent asset is defined in IAS 37 as:

… a possible asset that arises from past events and whose existence will be confirmed only by the
occurrence or non-occurrence of one or more uncertain future events not wholly within the control
of the entity (IAS 37, para. 10).
Contingent assets are not recognised in the statement of financial position. They are disclosed
in the notes to the financial statements. An example of a contingent asset provided by IAS 37
is ‘a claim that an entity is pursuing through legal processes, where the outcome is uncertain’
(IAS 37, para. 32). Another example is a buyer entitled to a full cash refund for faulty products
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purchased, who has made a refund claim during the warranty period, but the supplier is disputing
the claim and the dispute is being decided by an independent arbiter. Until the dispute has been
settled, the buyer has a contingent asset.
A possible asset is identified and disclosed in accordance with IAS 37. It is a contingent asset
if, after all the available evidence has been considered, the existence of an asset is still unclear
and will not be clarified until an uncertain future event that is not wholly within the control
of the entity occurs or fails to occur. In relation to the second part of the definition—dealing
with probability and reliable measurement—IAS 37 only requires disclosure when the inflow
of economic benefits is probable. This is consistent with the asset recognition criteria in the
Conceptual Framework.
Table 3.1 summarises the key requirements of IAS 37 in relation to contingent assets.
Table 3.1: Application of probability criteria to contingent assets
Probability of inflow of Accounting treatment in accordance with IAS 37 Provisions, Contingent

economic benefits Liabilities and Contingent Assets
Virtually certain Where the realisation of income is virtually certain, the asset is not a contingent
asset and it is appropriate to recognise the asset (IAS 37, para. 33).
Probable but not If there is a possible asset for which future benefits are probable, but not
virtually certain virtually certain, no asset is recognised (IAS 37, para. 31), but a contingent
asset is disclosed (IAS 37, para. 89).
Not probable If there is a possible asset for which the probability that future benefits will
eventuate is not probable, no asset is recognised (IAS 37, para. 31) and no
disclosure is required for the contingent asset (IAS 37, para. 89).
Source: Adapted from IFRS Foundation 2017, IAS 37 Provisions, Contingent Liabilities and
Contingent Assets, in 2017 IFRS Standards, IFRS Foundation, London.
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‘Guidance on Implementing IAS 37’, Part A ‘Tables—Provisions, contingent liabilities, contingent

assets and reimbursements’ in the Red Book 2016 provides a useful summary of these requirements.
If you wish to explore this topic further you may now read ‘Guidance on Implementing IAS 37’,
Part A (the part on contingent assets), in Part B of the Red Book 2016.
➤➤Question 3.10
Identify two further examples of contingent assets. For each example, explain why the item
would be a contingent asset rather than being recognised as an asset. Do you believe that the
reporting of contingent assets affects the decisions of equity investors or other finance providers?
Why or why not?
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IAS 37 requires disclosure of the nature of the contingent assets at the end of the reporting
period and, where practicable, an estimate of their financial effect. Estimates of contingent assets
are measured using the principles set out for the measurement of provisions in paras 36–52 of
IAS 37 (IAS 37, para. 89).
Contingent liabilities
IAS 37 adopts a broad concept of contingent liabilities. Contingent liabilities are defined as:
(a) a possible obligation that arises from past events and whose existence will be confirmed only
by the occurrence or non-occurrence of one or more uncertain future events not wholly within
the control of the entity; or
(b) a present obligation that arises from past events but is not recognised because:
(i) it is not probable that an outflow of resources embodying economic benefits will be
required to settle the obligation; or
(ii) the amount of the obligation cannot be measured with sufficient reliability (IAS 37, para. 10).
Contingent liabilities, like contingent assets, are not recognised in the statement of financial
position. IAS 37 requires the disclosure of contingent liabilities unless the possibility of an outflow
of resources is remote (IAS 37, para. 28).
IAS 37 explains that only those contingent liabilities described in para. 10(a) of the standard
are entirely contingent in nature. However, the standard setters have adopted the view that it is
useful to treat provisions that fail either or both of the recognition criteria as contingent liabilities.
This is done to achieve consistency with the treatment of possible liabilities in para. 10(a)
of IAS 37, and to enable simpler classification of provisions requiring either recognition and
disclosure or disclosure in a note without recognition in the statement of financial position.
If you wish to explore this topic further you may now read paras 27–30 of IAS 37 and ‘Guidance
on Implementing IAS 37’, Part A (the part on provisions and contingent liabilities) in Part B of the
Red Book 2017.
Table 3.2 summarises the key requirements of IAS 37 in relation to provisions and contingent
liabilities.
Table 3.2: Application of probability criteria to provisions and contingent liabilities
Accounting treatment in accordance with

Obligation and probability of outflow IAS 37 Provisions, Contingent Liabilities and
of economic benefits Contingent Assets
Present obligation that probably requires an outflow A provision is recognised (IAS 37, para. 14)
of resources Disclosures are required for the provision (IAS 37,
para. 84–85)
Possible obligation or present obligation that may, No provision is recognised (IAS 37, para. 27)
but probably will not, require an outflow of resources Disclosed as a contingent liability (IAS 37, para. 86)
Possible obligation or present obligation where the No provision is recognised (IAS 37, para. 27)
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likelihood of outflow of resources is remote No disclosure is required (IAS 37, para. 86)
Extremely rare case where there is a liability, but it No provision is recognised (IAS 37, para. 27)
cannot be measured reliably Disclosed as a contingent liability (IAS 37, para. 86)
Source: Adapted from IFRS Foundation 2017, IAS 37 Provisions, Contingent Liabilities and
Contingent Assets, in 2017 IFRS Standards, IFRS Foundation, London.
A contingent liability will exist in the event of:

1. a possible obligation to be confirmed by uncertain future events
2. a present obligation where the future sacrifice of economic benefits is not probable, or
3. a present obligation with a probable future sacrifice of economic benefits that is not
reliably measurable.
It is only when the probability of future sacrifice is higher than remote that the contingent liability
will be disclosed in a note to the financial statements. In the context of event (3), this is satisfied
as the future sacrifice is probable. For events (1) and (2), however, an assessment must be
made as to the degree to which the future sacrifice is unlikely. If it is remote, then no disclosure
is required.
A provision, however, exists in the event of a present obligation with a probable future sacrifice
of economic benefits, where a reliable estimate of the amount of the obligation can be made.
A provision is clearly distinct from event (1), which relates to a possible obligation, and event (2),
where the future sacrifice is not probable. As such, a provision most closely resembles event (3).
The distinction, however, is whether the estimate is sufficiently reliable to warrant recognition.
If the answer is ‘yes’, it is a provision. If the answer is ‘no’, as per event (3), it is disclosed as a
contingent liability.
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Example 3.14: D
etermining when to disclose a contingent
liability
Legal proceedings are commenced seeking damages from an entity due to food poisoning, possibly
caused by products sold by the entity. The entity disputes liability, and the entity’s lawyers initially advise
that it is probable that the entity will not be found liable. At this point in time, a possible obligation
(as per contingent liability event (1) ) exists that will be disclosed as a contingent liability unless the
probability of future sacrifice is remote.
If, however, owing to developments in the case it becomes probable that the entity will be found liable,
but the amount of damages to be awarded cannot be measured with sufficient reliability, a contingent
liability still exists (as per event (3)). Disclosure will be required as the future sacrifice is probable and,
thus, cannot be considered remote.
To extend this example, if a reliable estimate could be made of the damages to be awarded, the present
obligation would no longer be a contingent liability under event (3), but rather would be recognised
as a provision.
Source: Based on IFRS Foundation 2017, IAS 37 Provisions, Contingent Liabilities and
Contingent Assets, in 2017 IFRS Standards, IFRS Foundation, London, p. B2556.
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‘Guidance on Implementing IAS 37’, Part B, in the Red Book 2017 provides a decision tree that
clearly differentiates between the requirements for the recognition of an item as a provision,
disclosure of the item as a contingent liability or non-disclosure of the item.
If you wish to explore this topic further you may now read ‘Guidance on Implementing IAS 37’,
Part B (in Part B of the Red Book 2017).
Liabilities versus contingent liabilities

When it is determined whether a liability or a contingent liability exists, it will normally be
clear whether a past event has given rise to a present obligation. In rare cases where there
is uncertainty, the entity must consider all available evidence, including, where necessary,
the opinions of experts. This will also include information from events occurring between
the end of the reporting period and the time the financial statements are completed.
Where the existence of a present obligation is still unclear—and this will only be confirmed
by the occurrence or non-occurrence of some future event outside the control of the
entity—a possible obligation is identified and treated as a contingent liability.
For a past event to give rise to an obligation, the Conceptual Framework requires the entity to
have an irrevocable agreement to settle the obligation that was created. This is normally the
case where the settlement of the obligation is legally enforceable as a consequence of a binding
contract or statutory requirement. An obligation may also arise as a result of custom, a desire to
maintain good business relations or a desire to act in an equitable manner. These obligations
arise where valid expectations that the entity will discharge the obligation are created in
other parties.
Contingencies and professional judgment

An accountant must exercise professional judgment in determining whether an item should be
recognised as a financial statement element or whether it constitutes a contingency. For example,
an accountant must assess whether, after all available evidence has been considered, it is clear
that an asset exists. If it is clear, the asset must be recognised in the statement of financial
position, provided it satisfies both recognition hurdles (i.e. probable occurrence and reliable
measurement). If it is unclear, a contingent asset exists. An accountant must then exercise
professional judgment in determining whether the inflow of economic benefits is probable,
which then requires disclosure of the contingent asset.
Similarly, professional judgment is required by an accountant in concluding whether a liability

or contingent liability exists, and if it is a contingent liability, whether the liability is to be
disclosed. An accountant must decide whether an obligation is a possible or present obligation.
If it is a possible obligation, a contingent liability exists and must be disclosed. If it is a present
obligation, the accountant must determine whether an outflow of resources is probable and
whether the amount of the obligation is reliably measurable. When an outflow is probable and
the amount is reliably measurable, a liability must be recognised. However, when an outflow
is not probable or the amount cannot be measured reliably, the obligation is a contingent
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liability that must be disclosed provided the likelihood of future sacrifice is higher than remote.
When deciding on the nature of the obligation, the probability of an outflow occurring and
whether the amount of an obligation is reliably measurable, an accountant is required to exercise
professional judgment. The consequence of exercising this judgment is whether the obligation
is recognised, disclosed or not reported.
When a contingency is required to be disclosed, an accountant must also exercise discretion

in deciding the extent to which potentially sensitive information is made public. For example,
an entity subject to a strong legal claim that has been brought against it, where the outcome
is uncertain, has a contingent liability. In applying the disclosure requirements of para. 86 of
IAS 37, the entity must disclose a brief description of the legal claim and, where practicable,
best estimate of the amount required to settle the claim, an indication of any uncertainties
surrounding the amount or timing of the settlement, and the possibility of reimbursement
through insurance. An entity, however, will be reluctant to give extensive details about the
legal claim for fear of prejudicing the outcome or jeopardising settlement negotiations.
Moreover, while an entity has commercial reasons for disclosing confidence in their ability to
defend the claim, this may be misleading to financial statement users. An accountant must,
therefore, exercise professional judgment in ensuring IAS 37 disclosure requirements are met,
but not at the cost of releasing sensitive information that would prove harmful to the entity.
Summary
This part reviewed the requirements of IAS 37 in relation to contingent liabilities and contingent
assets.
The objective of IAS 37 is to assist users in assessing the nature and amount of contingent assets
and contingent liabilities of an entity. Through the disclosure of information on contingent
assets and contingent liabilities, financial statement users are made aware of assets and liabilities
that, while not recognised in the entity’s financial statements, may affect an entity’s financial
position in the future, and, in so doing, enable users to make more informed decisions.
Study guide | 247
Review
This module examined the requirements of both IFRS 15, in relation to the recognition of revenue
from customers, and IAS 37, in relation to accounting for provisions, contingent liabilities and
contingent assets.
In Part A, the five-step model for revenue recognition was discussed, beginning with a discussion
on identifying whether a contract with a customer exists. Given the presence of such a contract,
Part A then explored identifying the performance obligation(s) within the contract and quantifying
the transaction price of the contract. How to allocate the transaction price to each performance
obligation was then considered, followed by when to recognise revenue under the contract.
Finally, the accounting treatment of contract costs and the disclosure requirements of IFRS 15
were reviewed—the aim of the disclosures under IFRS 15 being to provide financial statement
users with an understanding of the revenue practices of the entity.
In Part B, provisions were discussed and identified as a subset of liabilities. The definition and
recognition criteria for liabilities were reviewed as a basis for understanding the requirements
for the recognition of provisions. The disclosures relating to provisions were described,
as well as how they assist users in understanding the reasons behind, and the uncertainty
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of, the recognised amount.
Contingent liabilities and contingent assets were covered in Part C. The relationship between
assets and contingent assets was explored, and a summary of the requirements for their
disclosure provided. Contingent liabilities were also discussed, and the provisions of IAS 37
were compared with the position of the Conceptual Framework in relation to liabilities.
IAS 37 requires that neither contingent liabilities nor contingent assets be recognised in the
statement of financial position, but they should be disclosed by way of a note. These disclosures
provide users with a better understanding of the assets, whether recognised or contingent,
and liabilities, whether arising from possible or present obligations, of an entity.
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Suggested answers
Suggested answers
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Question 3.1
At the agreement’s inception, the construction company will apply the requirements of IFRS 15 to
the agreement to construct the shopping centre. This is because there is a contract (the three‑year
agreement) with a customer (the property developer) that appears to possess all the attributes
outlined in para. 9 of IFRS 15.
After 12 months, however, there is a significant change in facts and circumstances. The property
developer is experiencing significant financial difficulties. This significant change in the customer’s
circumstances requires the construction company to reassess whether the agreement contains all
the attributes in para. 9 of IFRS 15. As it is no longer probable that the construction company will
collect the consideration, IFRS 15 no longer applies to the agreement. The construction company
can continually reassess the agreement to determine whether all attributes are present again.
Question 3.2
First, because the software is delivered before the other goods and services, and it functions
without the updates and technical support, the customer can benefit from each of the goods and
services on their own or together with the other goods and services. As such, each of the goods
and services satisfies the criterion in para. 27(a) of IFRS 15.
Second, the promise to transfer each good and service to the customer is separately identifiable
from each of the other promises. As indicators of this, the entity is not providing a significant
service of integrating the software and services into a combined output, given the software
functions without the updates and technical support and each can be sold separately. Moreover,
the promised goods or services do not significantly modify or customise each other, as the
installation service does not significantly modify the software itself. Finally, the software
and services are not highly interdependent or highly interrelated as the software functions
independently of the updates and technical support (see IFRS 15, para. 29). Thus, each of the
goods and services satisfies the criterion in para. 27(b) of IFRS 15.
As both paras 27(a) and (b) are satisfied for each of the goods and services provided under the
contract, each constitutes a distinct good or service. Each distinct good or service gives rise to
a separate performance obligation. On this basis, the software developer would identify four
performance obligations:
1. the software licence
2. installation service
3. software updates
4. technical support.
Question 3.3
Contract for construction of office block
The consideration promised under this contract is a combination of both fixed and variable
amounts. The $1 500 000 represents fixed consideration, as the construction company is entitled
to this amount on completion of the office block independent of the timeliness of completion.
The $350 000 is variable consideration, as it is a performance bonus in accordance with para.
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50 of IFRS 15. The construction company is only entitled to the $350 000 if the office block is
completed within 18 months. If not, the construction company does not receive this amount.
As such, whether the construction company receives $350 000 varies according to the timeliness
of completion.
Contract for construction of warehouse

The consideration promised under this contract is a combination of both fixed and variable
amounts. The amount of $450 000 ($500 000 – $50 000) is fixed, as the entity is entitled to this
amount irrespective of whether the penalty is imposed. The $50 000 arising from the penalty
is variable in accordance with para. 50 of IFRS 15, as it is dependent on whether construction is
completed by 31 August 20X6.
Question 3.4
In accordance with para. 91 of IFRS 15, the entity recognises an asset for $12 500 as the
incremental costs of obtaining the contract. This amount relates to the commissions to sales
employees for obtaining the contract, which would not have been incurred if the contract had
not been obtained. Further, the entity expects to recover those costs through future fees for
the consulting services. As the contract is for three years, the amortisation period is longer than
one year.
The travel costs to deliver the proposal ($20 000) and the portion of legal fees payable irrespective
of the success of the tender ($10 000) are not incremental and cannot be recognised as an asset.
In relation to the $15 000 legal fees payable on the tender being successful, although incremental,
the entity would not expect to recover these costs either directly or indirectly. As such, these costs
would be expensed as incurred.

Question 3.5
An obligation to repair or replace goods sold if they are determined to be faulty
An obligation to repair or replace goods sold is likely to be a provision within the scope of IAS 37.
As a result of a past obligating event (i.e. the sale of the goods), this is a present obligation that
is probable for an uncertain portion of the goods returned.
A warranty provided for a television sold by a retailer

An obligation relating to a warranty provided on the sale of a television is likely to be a provision
within the scope of IAS 37. A warranty generally involves the retailer (or manufacturer) warranting
to make good, either by repair or replacement, any defects to the goods sold within a specified
period. As a result of a past obligating event (i.e. the sale of the television with the warranty),
this is a present obligation that is probable for an uncertain amount, depending on how many
televisions require repair or replacement.
Annual leave
Annual leave payable to employees is an example of a liability covered by another standard
and, therefore, not within the scope of IAS 37. The requirements for recognising provisions for
annual leave are dealt with as a short-term compensated absence in IAS 19 Employee Benefits.
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Question 3.6
For a provision to be recognised, IAS 37 requires that:
(a) an entity has a present obligation (legal or constructive) as a result of a past event;
(b) it is probable that an outflow of resources embodying economic benefits will be required to
settle the obligation; and
(c) a reliable estimate can be made of the amount of the obligation (IAS 37, para. 14).
In this example, the manufacturer has a present legal obligation. The obligating event is the
sale of the product with a warranty.
IAS 37 outlines that the future sacrifice of economic benefits is probable when it is more likely
than less likely that the future sacrifice of economic benefits will be required. In this example,
the probability that settlement will be required will be determined by considering the class of
obligation (warranties) as a whole (IAS 37, para. 24). In accordance with para. 24, it is more likely
than less likely that a future sacrifice of economic benefits will be required to settle the class of
obligations as a whole.
The final criterion in para. 14(c) of IAS 37 must be met before a provision can be recognised.
If a reliable estimate can be made the provision can be measured reliably. Past data can provide
reliable measures, even if the data is not firm-specific but rather industry-based. Paragraph
25 of IAS 37 notes that only in ‘extremely rare cases’ can a reliable measure of a provision not
be obtained. Difficulty in estimating the amount of a provision under conditions of significant
uncertainty does not justify non-recognition of the provision.
Conclusion
The manufacturer should recognise a provision based on the best estimate of the consideration
required to settle the present obligation as at the reporting date.

Question 3.7
The expected value of the cost of repairs in accordance with IAS 37 is:
(80% × nil) + (15% × $2m) + (5% × $5m) = 300 000 + 250 000 = 550 000
Question 3.8
Provision for warranties—Techworks Ltd’s compliance with IAS 37
Disclosure in Techworks Ltd’s 2016 financial statements

IAS 37 para. 85 requirement (Note 15 ‘Provisions’)
A brief description of the nature ‘Provision is made for estimated warranty claims in respect of
of the obligation products sold which are still under warranty at the end of the
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reporting period.’
The expected timing of any ‘These claims are expected to be settled in the next financial year.’
resulting outflows of economic
benefits
An indication of the uncertainties ‘Management estimates the provision based on historical warranty
about the amount or timing of claim information and any recent trends that may suggest future
those outflows. Where necessary claims could differ from historical amounts.’
to provide adequate information,
an entity shall disclose the major
assumptions made concerning
future events, as addressed in
para. 48 of IAS 37
The amount of any expected Techworks Ltd provides no disclosure in relation to any reimbursement.
reimbursement, stating the As such, it may be assumed that no such reimbursement is expected,
amount of any asset that has or if any is expected, it is immaterial to the financial statements.
been recognised for that
expected reimbursement

Question 3.9
Earnings management could be decreased due to the increased transparency of the movement
in provisions. As a result of the increased disclosure requirements, users are able to determine:
• the carrying amount of provisions at the beginning of the reporting period;
• additional provisions made during the reporting period; and
• amounts used (i.e. incurred and charged against the provision) during the period
(IAS 37, para. 84).
Therefore, users are able to establish the increase and decrease in provisions, including the
subsequent write-back of provisions.
Question 3.10
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You could have included a range of examples of contingent assets from your own knowledge
and experience. One example is an application by the entity for damages or compensation in
a court of law; if successful, the entity will receive a cash payment. This would be a contingent
asset because the future economic benefit will be confirmed only by the decision of the court.
Another example of a contingent asset is when an entity is expecting to receive future economic
benefits from an estate, but the amount to be received is uncertain at the reporting date.
The reporting of contingent assets may have an effect on the decisions of equity investors or
other finance providers, who make their assessment based on the likelihood of a contingent
asset becoming the entity’s asset. If the asset does crystallise, it is likely to have an effect on
performance ratios, such as leverage, and may assist the entity in meeting its debt covenants.

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References | 255
References
References
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Washington, S. 2002, ‘Smooth accusations’, Business Review Weekly, 24 October, pp. 74–5.
Optional reading
IFRS Foundation 2017, 2017 IFRS Standards, IFRS Foundation, London.
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FINANCIAL REPORTING
Module 4
INCOME TAXES
258 | INCOME TAXES
Contents
Preview 261
Introduction
Objectives
Teaching materials
Part A: Income tax fundamentals 263

Introduction 263
Tax expense 265
Current tax 266
Calculating current tax
Recognition of current tax
Deferred tax 269
Step 1: Determining the tax base of assets and liabilities
Step 2: Compare the tax base to the carrying amount to determine
temporary differences
Step 3: Measure deferred tax assets and deferred tax liabilities
Summary 287
Part B: Recognition of deferred tax assets and liabilities 288

Introduction 288
Recognition of deferred tax liabilities 288
Recognition of deferred tax assets 290
Recognition of deferred tax
Recognition rules for unused tax losses and unused tax credits
Recoupment of tax losses 299
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Reassessment of the carrying amounts of deferred tax assets and liabilities

Summary 305
Part C: Special considerations for assets measured

at revalued amounts 306
Introduction 306
Assets carried at revalued amounts 306
Recognition of deferred tax on revaluation 308
Recovery of assets through use or through sale
Additional guidance on recovery of non-depreciable assets
Summary 315
Part D: Financial statement presentation and disclosure 316

Introduction 316
Presentation of current tax and deferred tax 317
Offsetting tax assets and liabilities
Major components of tax expense 319
Relationship between tax expense (income) and accounting profit 321
Information about each type of temporary difference 324
Summary 326
Part E: Comprehensive example 327

Introduction 327
Background to AAA Ltd
Carrying amounts and tax base of buildings 329
Other deferred tax assets and liabilities 332
Taxable profit and current tax expense 333
Illustrative disclosures 335
Summary 336
CONTENTS | 259
Review 337
References 357
MODULE 4
MODULE 4
Study guide | 261
Module 4:
Income taxes
Study guide
Preview
Introduction
MODULE 4
Income taxes are paid by individuals and entities in most countries according to the tax rates
and tax laws of the relevant jurisdiction.
As a significant business expense for many entities, it is important for users and preparers of
financial statements to have a clear understanding of the way income tax expense, and the related
income tax assets and liabilities, are calculated and recognised in the financial statements.
The objective of IAS 12 Income Taxes is to prescribe the accounting treatment for income taxes.
The method prescribed by IAS 12 to account for income taxes is commonly referred to as the
‘balance sheet liability method’. This is because a major aspect of the calculation of income tax
expense, and the related income tax assets and liabilities, under IAS 12 requires consideration
of the difference between the carrying amounts of assets and liabilities (as recognised in the
financial statements) and the underlying tax base of those assets and liabilities (as determined
according to the tax rates and tax laws enacted in the relevant jurisdiction).
In general terms, the use of the balance sheet liability method of accounting for income taxes
will result in the entity recognising the current and future tax consequences of:
• transactions and other events of the current period that are recognised in an entity’s
• the future recovery (settlement) of the carrying amount of assets (liabilities) that are
recognised in an entity’s statement of financial position.
This module discusses the rationale underpinning the balance sheet liability method of accounting
for income tax and examines the fundamentals of this approach. More specifically, the module
provides guidance and illustrative examples as to the recognition and measurement of tax
expense (tax income), current tax, deferred tax assets and deferred tax liabilities.
262 | INCOME TAXES
The following is a brief overview of the structure of the module:

• Part A Income tax fundamentals—discusses the core principle of IAS 12 and explores the
nature of the income tax balances recognised in the financial statements and the practical
approach to their determination.
• Part B Recognition of deferred tax assets and liabilities—examines the separate recognition
rules (and limited recognition exceptions) for the recognition of deferred tax assets and
deferred tax liabilities in the financial statements.
• Part C Special considerations for assets measured at revalued amounts—deals with the
recognition and measurement of deferred tax liabilities that arise when assets are carried at
revalued amounts.
• Part D Financial statement presentation and disclosure—illustrates the disclosure information
that enables users of the financial statements to understand and evaluate the impact of
current tax and deferred tax on the financial position and performance of the entity.
• Part E Comprehensive example—contains a comprehensive example illustrating the
application of IAS 12.
Objectives
• explain the terms ‘taxable temporary differences’ and ‘deductible temporary differences’;
• apply the requirements of IAS 12 with respect to current and deferred tax assets and liabilities;
• apply the tax rates and tax bases that are consistent with the manner of recovery or
settlement of an asset or liability;
• apply the probability recognition criterion for deductible temporary differences, unused tax
losses and unused tax credits;
• account for the recognition and reversal of deferred tax assets arising from deductible
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temporary differences, unused tax losses and unused tax credits;

• determine the deferred tax consequences of revaluing property, plant and equipment; and
• apply the requirements of IAS 12 with respect to financial statement presentation and
disclosure requirements.
Teaching materials
• IAS 12 Income Taxes
• Comprehensive example
To explain the rationale and application of IAS 12, there is a comprehensive example in
Part E. You should familiarise yourself with the data in this example.
• A Learning Task on My Online Learning supports this module. The Income Taxes Learning
Task includes a discussion of deferred tax assets and liabilities, tax expense and disclosure
requirements, and provides the opportunity for further practice.
Note that while the Income Taxes Learning Task provides valuable reinforcement of the
module discussion, it is not mandatory to use this resource.
Unless otherwise indicated, a tax rate of 30 per cent has been adopted throughout this module.
Study guide | 263
Part A: Income tax fundamentals

Introduction
Part A of this module examines the fundamentals of accounting for income tax under IAS 12.
As explained in the Preview to the module, the core principle of IAS 12 is that the financial
statements should recognise the current and future tax consequences of:
These current and future tax consequences are reflected in the financial statements as
‘current tax liability’, ‘deferred tax assets’, ‘deferred tax liabilities’ and ‘tax expense’, as shown
in Table 4.1 and Table 4.2.
Table 4.1: Income tax line items in financial statements
Current tax liability The amount of tax payable to the taxation authorities for current and
prior periods, to the extent unpaid at the end of the financial year
(IAS 12 Income Taxes, para. 12).
Deferred tax assets The ‘amounts of income taxes recoverable in future periods in respect of:
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(a) deductible temporary differences [which are future deductible
amounts that will result from the realisation of assets or the
settlement of liabilities];
(b) the carryforward of unused tax losses; and
(c) the carryforward of unused tax credits’ (IAS 12, para. 5).
Deferred tax liabilities The ‘amounts of income taxes payable in future periods in respect
of taxable temporary differences [which are future taxable amounts that
will result from the realisation of assets or the settlement of liabilities]’
(IAS 12, para. 5).
Tax expense (tax income) The ‘aggregate amount included in the determination of profit or loss for
the period in respect of current tax and deferred tax’ (IAS 12, para. 5).
Source: Adapted from IFRS Foundation 2017, IAS 12 Income Taxes, para. 5,
in 2017 IFRS Standards, IFRS Foundation, London, p. A859.
264 | INCOME TAXES
Table 4.2: Financial statement extracts

20X1 20X0
$ $
Income 975 000 857 000
Expenses (325 000 ) (232 000 )
Profit before income tax 650 000 625 000
Tax expense (195 000 ) (187 500 )
Profit for the year 455 000 437 500
Statement of financial position at 30 June 20X1
20X1 20X0
$ $
Current assets
Cash 433 500 143 000
Trade and other receivables 375 500 216 000
Non-current assets
Property, plant and equipment 1 450 000 1 410 000
Deferred tax assets 15 000 13 500
Total assets 2 274 000 1 782 500

Current liabilities
Trade and other payables (115 000 ) (95 000 )
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Current tax liabilities (191 500 ) (185 000 )
Provisions (35 000 ) (30 000 )

Borrowings (500 000 ) (500 000 )
Deferred tax liabilities (65 000 ) (60 000 )
Provisions (15 000 ) (15 000 )

Total liabilities (921 500 ) (885 000 )
Net assets 1 352 500 897 500
Part A explores the nature of the income tax balances recognised in the financial statements
and the practical approach to their determination.
Note that the fundamentals outlined in Part A are essential to understanding the more advanced
concepts addressed in Parts B–E.
Study guide | 265
Relevant paragraphs
To assist in achieving the objectives of Part A outlined in the module preview, you may wish to
read the following paragraphs of IAS 12. Where specified, you need to be able to apply these
paragraphs as referenced in this module:
Subject Paragraphs
Definitions 5–6
Tax base 7–11
Recognition of current tax liabilities and current tax assets 12–14
Recognition of deferred tax liabilities and deferred tax assets 15–18
Deductible temporary differences 24–25, 26(a), 26(b), 26(d), 27–31
Measurement 46–56
Recognition of current and deferred tax 57–60
Illustrative Examples (Part B of the Red Book) Part A (paragraphs 1–11)
Part B (paragraphs 1–8)
Part C (paragraphs 1–4)
Example 2
Tax expense
As illustrated in the financial statement extract in Table 4.2, income tax expense (tax income)
is presented as a separate line item in the statement of profit or loss and other comprehensive
income (P&L and OCI).
Tax expense is the sum of current tax and deferred tax recognised in the P&L for the period
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(IAS 12, para. 5). It is possible for tax expense to be negative, in which case it is described as tax
income and has a credit balance.
Figure 4.1: Tax expense
Tax expense Current tax expense Deferred tax expense

= +
(Tax income) (Current tax income) (Deferred tax income)
Amount of income tax Movement in deferred

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

266 | INCOME TAXES
As outlined in Figure 4.1, tax expense (tax income) comprises two components (i.e. ‘current
tax expense’ and ‘deferred tax expense’). Each component is calculated separately and then
aggregated to comprise ‘tax expense’ for the reporting period.
As outlined in the Objective of IAS 12, the rationale for the recognition of ‘deferred tax assets’,
‘deferred tax liabilities’ and ‘deferred tax expense’ (in addition to the recognition of ‘current tax
expense’) is that:
• It is inherent in the recognition of an asset or liability that the reporting entity expects to
recover or settle the carrying amount of that asset or liability (IAS 12, Objective).
• If it is probable that recovery or settlement of that carrying amount will make future tax
payments larger (smaller) than they would be if such recovery or settlement were to have
no tax consequences, this Standard requires an entity to recognise a deferred tax liability
(deferred tax asset), with certain limited exceptions (IAS 12, Objective).
From a conceptual perspective, the future tax consequences of the expected recovery (settlement)
of the carrying amounts of assets (liabilities) recognised in the statement of financial position
provides a more complete picture of the financial position of the entity.
A detailed discussion of the determination of current tax expense, deferred tax expense (and the
associated deferred tax assets and deferred tax liabilities) is contained in the following sections.
If you wish to explore this topic further you may now read the definitions of the following terms in
paras 5 and 6 of IAS 12: accounting profit, taxable profit (tax loss), tax expense (tax income) and
current tax.
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Current tax
As illustrated in Figure 4.1, the first component of tax expense is current tax expense.
Current tax expense is the ‘amount of income taxes payable (recoverable) in respect of taxable
profit (tax loss) for the period’ (IAS 12, para. 5).
The key steps for accounting for current tax are shown in Table 4.3.
Table 4.3: Key steps in accounting for current tax
Step 1 Calculate the ‘amount expected to be paid to (recovered from) the taxation authorities,
using the tax rates (and tax laws) that have been enacted or substantively enacted by the
end of the reporting period’ (IAS 12 Income Taxes, para. 46).
Step 2 Recognise the amount of current tax in P&L for the period, in OCI, or directly in equity,
as appropriate (IAS 12, para. 58).
Source: Adapted from IFRS Foundation 2017, IAS 12 Income Taxes, paras 46, 58,
in 2017 IFRS Standards, IFRS Foundation, London, pp. A784, A880.
Study guide | 267
Each step will now be discussed.
Calculating current tax

From a practical perspective, current tax is generally calculated by either:
• directly applying the relevant tax laws and tax rate to the transactions and other events
of the current reporting period, or
• adjusting the accounting profit of the current reporting period for differences between
accounting and tax treatments to indirectly determine taxable profit and apply the relevant
tax rate.
The approach of adjusting the accounting profit to indirectly determine taxable profit is
illustrated in Example 4.1.
Example 4.1: C
alculate current tax by adjusting the
accounting profit for the reporting period
The P&L and OCI of Hi-sales Ltd for the financial year ending 30 June 20X0 was as follows:
$ $
Income
Sales 2 540 000
Expenses
Cost of goods sold 1 735 000
Depreciation—equipment 12 000
Other expenses 40 000 (1 787 000 )
Profit before tax 753 000
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• For tax purposes, depreciation on the plant and equipment for the current period is $14 000.
• ‘Other expenses’ of $40 000 includes entertainment expenses that are not deductible for tax
purposes of $3000.
The taxable profit of Hi-sales Ltd can be calculated as follows:
$ $
Add:
Non-deductible entertainment expenses† 3 000
756 000
Less:
Excess of tax depreciation deduction over
accounting depreciation expense‡ 2 000
Taxable profit 754 000
†
The entertainment expense of $3000 is non-deductible and will not be included when determining taxable
profit. This is an example of a non-temporary difference, which must be added back to accounting profit.
‡
Depreciation expense for accounting purposes is $12 000 but for tax purposes is $14 000. Therefore,
an additional $2000 of depreciation must be deducted from accounting profit in calculating taxable profit.
Assume that the tax rate is 30 per cent. We calculate current tax by multiplying taxable profit by the
tax rate ($754 000 × 30% = $226 200).
268 | INCOME TAXES
Recognition of current tax

IAS 12 (para. 58) provides the following for recognising items in P&L.
Current and deferred tax shall be recognised as income or an expense and included in profit or loss
for the period, except to the extent that the tax arises from:
(a) a transaction or event which is recognised, in the same or a different period, outside profit or
loss, either in other comprehensive income or directly in equity …; or
(b) a business combination (other than the acquisition by an investment entity, as defined in
IFRS 10 Consolidated Financial Statements, of a subsidiary that is required to be measured
at fair value through profit or loss) … (IAS 12, para. 58).
(Refer to Module 5 for discussion of deferred tax arising from a business combination.)
For items recognised outside P&L, IAS 12 (para. 61A) requires that current tax and deferred tax
shall be recognised outside of P&L if the tax relates to items that are also recognised, outside of
the P&L in the same or different period. Therefore, current tax and deferred tax that relates to
such items are recognised:
• in OCI where the item is recognised in OCI
• directly in equity where the item is recognised directly in equity (IAS 12, para. 61A).
If you wish to explore this topic further you may now read paras 58 and 61A of IAS 12.
In addition to recognising the amount of current tax in P&L for the period, in OCI, or directly in
equity (as discussed), an entity must also recognise the amount payable to (refundable from) the
taxation authorities as an asset or liability, as follows:
• Current tax for current and prior periods shall, to the extent unpaid, be recognised as a liability.
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If the amount already paid in respect of current and prior periods exceeds the amount due for
those periods, the excess shall be recognised as an asset (IAS 12, para. 12).
• The benefit relating to a tax loss that can be carried back to recover current tax of a previous
period shall be recognised as an asset (IAS 12, para. 13).
This is illustrated in Example 4.2.
Example 4.2: Recognition of a current tax liability

Using the data from Example 4.1, current tax of Hi-sales Ltd for the financial year ending 30 June 20X0
was determined to be $226 200. Assume that, in addition to the information provided, the relevant
tax laws required Hi-sales Ltd to pay tax instalments during the financial year ending 30 June 20X0
based on Hi-sales’ estimate of its taxable profit for the year. Based on Hi-sales’ estimate of its taxable
profit for the financial year ending 30 June 20X0, instalments amounting to $185 000 were paid to the
relevant taxation authority prior to 30 June 20X0.
Using the above information, the current tax liability recognised by Hi-sales Ltd in the statement of
financial position at 30 June 20X0 would be $41 200 ($226 200 – $185 000).
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Deferred tax
As illustrated in Figure 4.1, the second component of tax expense is deferred tax expense,
which is the movement in deferred tax assets and deferred tax liabilities for the reporting period
recognised in P&L.
In principle, deferred tax is the future tax consequences (as distinct from current tax consequences)
of the future recovery of assets and the future settlement of liabilities (IAS 12, Objective).
The recognition and measurement of deferred tax assets and deferred tax liabilities requires
an assessment of the future tax consequences of the future realisation/future settlement of all
assets/liabilities of the entity (as recorded in the statement of financial position).
The key steps required to recognise and measure deferred tax are shown in Table 4.4.
Table 4.4: Key steps for calculating deferred tax
Step 1 Determine the tax base of assets and liabilities (IAS 12 Income Taxes, paras 7–11).
Step 2 Compare the tax base with the carrying amount of assets and liabilities to determine
taxable temporary differences and deductible temporary differences (IAS 12, para. 5).
Step 3 Measure deferred tax assets (arising from deductible temporary differences) and deferred
tax liabilities (arising from taxable temporary differences) (IAS 12, paras 46–56).
Step 4 Recognise deferred tax assets (arising from deductible temporary differences) and deferred
tax liabilities (arising from taxable temporary differences), taking into account the limited
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recognition exceptions (IAS 12, paras 15–45).
Source: Adapted from IFRS Foundation 2017, IAS 12 Income Taxes,

in 2017 IFRS Standards, IFRS Foundation, London.
Each of these steps is discussed in turn. Steps 1 to 3 are discussed in the remainder of Part A
and Step 4 is discussed in Part B.
In order to implement these steps, it is important to understand the terms ‘carrying amount’,
‘tax base’, ‘temporary difference’, ‘deferred tax assets’ and ‘deferred tax liabilities’. Except for
carrying amount, these terms are defined in para. 5 of IAS 12. Their basic meanings are
as follows.
Carrying amount
The carrying amount is the amount at which an asset or liability is recognised in the statement of
financial position. For an asset, this is the ‘amount at which an asset is recognised after deducting
any accumulated depreciation (amortisation) and accumulated impairment losses thereon’
(IAS 36, para. 6).
270 | INCOME TAXES
Tax base
The tax base of an asset or liability is the ‘amount attributed to that asset or liability for tax
purposes’ (IAS 12, para. 5). The tax base can also be described as the written-down value,
or carrying amount, of the asset or liability for tax purposes. To assist with understanding the
term, it may be helpful to assume the existence of a hypothetical balance sheet for tax purposes.
For example, assume that an entity acquires an item of equipment for $10 000, and the
applicable tax laws allow the entity to claim future tax deductions equal to the $10 000 original
cost of the equipment (by way of tax deductible depreciation). Under this scenario, at the date
of acquisition the tax base of the equipment is $10 000.
Example 4.3: Future tax consequences of settling a liability

An entity recognises a liability and related expense for employee benefits in 20X1 of $20 000,
which remains unsettled at the end of the financial year (30 June 20X1), and the entity will obtain a
tax deduction for the $20 000 expense at the time of settlement (i.e. when paid in cash in a future
period). As the future settlement of the employee benefit liability will result in a future deductible
amount (as there are no future taxable amounts), the entity recognises a deferred tax asset and related
deferred tax income of $6000 for the financial year ended 20X1 ($20 000 × 30% tax rate).
From the perspective of the statement of financial position, at 30 June 20X1, the entity will recognise
the employee benefit liability of $20 000 and a deferred tax asset of $6000. In combination, this reflects
the ‘after tax’ effect of the transaction on the financial position of the entity.
Temporary difference
A temporary difference is the difference ‘between the carrying amount of an asset or liability in
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the statement of financial position and its tax base’ (IAS 12, para. 5). These differences will reverse
over time and, as they increase or decrease, they will affect deferred tax balances.
A temporary difference reflects the future tax consequences of realising an asset or settling
a liability (i.e. the extent to which the realisation of an asset or the settlement of a liability will
result in future taxable income or future tax deduction).
For example, assume that the carrying amount of an item of equipment is $10 000, and the tax
base (determined under the applicable tax laws) is $8000. Under this scenario, the temporary
difference is $2000 ($10 000 – $8000). This reflects that there are future tax consequences of
realising the carrying amount of the asset (i.e. future taxable amounts will occur).
Temporary differences are classified as either ‘deductible temporary differences’ or ‘taxable

temporary differences’. These terms are defined below.
Taxable temporary difference

Taxable temporary differences are temporary differences that ‘will result in taxable amounts
in determining taxable profit (tax loss) of future periods when the carrying amount of the
asset or liability is recovered or settled’ (IAS 12, para. 5).
For example, assume that the carrying amount of land is $750 000, and its tax base
(determined under the applicable tax laws) is $500 000. Under this scenario, the temporary
difference is $250 000. As this temporary difference will result in taxable amounts of a future
period (when the asset is realised), because the entity creates taxable income, the temporary
difference is classified as ‘taxable temporary difference’.
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Deductible temporary difference

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

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

These are amounts of income taxes payable in the future and arise from taxable temporary
differences (IAS 12, para. 5).
These definitions lead to the formulas shown in Figure 4.2.
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Figure 4.2: Temporary differences and deferred tax assets/liabilities
Temporary Carrying amount of Tax bases of assets

= –
differences assets or liabilities or liabilities
Deferred tax Temporary

= × Tax rate
assets/liabilities differences
If you wish to explore this topic further you may now read the definitions of ‘tax base’,
‘temporary differences’, ‘deferred tax assets’ and ‘deferred tax liabilities’ in para. 5 of IAS 12.
While working through the remainder of this module, it is useful to keep in mind that the
objective of calculating the tax base is to determine, for each item concerned, whether a
deferred tax amount arises. As noted previously, the fundamental principle for determining
whether deferred tax amounts arise is as follows:
… an entity shall, with certain limited exceptions, recognise a deferred tax liability (asset)
whenever recovery or settlement of the carrying amount of an asset or liability would make
future tax payments larger (smaller) than they would be if such recovery or settlement were to
have no tax consequences … (IAS 12, para. 10).
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Step 1: Determining the tax base of assets and liabilities

The tax base of assets
The tax base of an asset is the ‘amount that will be deductible for tax purposes against any
taxable economic benefits that will flow to an entity when it recovers the carrying amount of
the asset. If those economic benefits will not be taxable, the tax base of the asset is equal to its
carrying amount’ (IAS 12, para. 7).
The formula shown in Figure 4.3 is based on the formula in para. 5.1 of the now superseded
Australian Accounting Standard AASB 1020 Income Taxes. This is useful when calculating the tax
base of an asset.
Figure 4.3: Tax base of an asset
Future
Tax base Carrying Future taxable
= + deductible –
of an asset amount amounts
amounts
Source: Based on AASB (Australian Accounting Standards Board) 1999, AASB 1020 Income Taxes,
para. 5.1, p. 24, accessed November 2017, http://www.aasb.gov.au/admin/file/content102/c3/
AASB1020_12-99.pdf.
In the formula in Figure 4.3:

• the carrying amount is the amount recognised in the financial statements. It is net of any
measurement adjustments (e.g. allowance for doubtful debts)
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• the future deductible amounts are the allowable tax deductions that would arise from the
realisation of the carrying amount of the asset
• the future taxable amounts are the taxable amounts that would arise from the realisation of
the carrying amount of the asset.
Example 4.4 outlines two scenarios for calculating the tax base.
Example 4.4: Calculating the tax base

Scenario 1 (IAS 12, para. 7, Example 1)
A machine cost $100. Depreciation of $30 has already been expensed for accounting purposes and
deducted for tax purposes in the current and prior periods—that is, the accounting treatment and tax
treatment are the same.
The carrying amount of the asset is original cost less accumulated accounting depreciation
($100 – $30 = $70). The remaining future economic benefits of the asset (cost of $70) will be subject
to depreciation and/or impairment in future periods.
Future deductible amounts are calculated as original cost less accumulated tax depreciation deductions
($100 – $30 = $70). The remaining cost of $70 will be tax deductible in future periods, either as
depreciation or through a deduction on disposal.
In this scenario, when the entity uses the asset it generates economic benefits in the form of revenue.
The revenue generated by using the machine is taxable, any gain on disposal of the machine will be
taxable and any loss on disposal will be deductible for tax purposes. Therefore, as the future economic
benefits, in the form of revenue, are taxable, the future taxable amounts associated with the asset are
equal to the carrying amount of $70.
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The following formula shows that the tax base of the machine is $70.
Future
Carrying Future taxable
Tax base deductible
= amount + – amounts
70 amounts
70 70
70
Scenario 2
Another item of plant was purchased two years ago for $100. This plant is being depreciated on a
straight-line basis for accounting purposes over a four-year period and on a straight-line basis for tax
purposes over a five-year period. There is no residual value for either tax or accounting purposes.
The income generated by the plant is included in taxable profit (loss), and tax depreciation is deductible
for tax purposes.
The carrying amount is calculated as original cost ($100) less accumulated accounting depreciation
($100 / 4 × 2 = $50) = $50. This is the net amount that would be recorded in the financial statements.
Future deductible amounts are calculated as original cost ($100) less accumulated tax depreciation
deductions ($100 / 5 × 2 = $40) = $60.
In this scenario, when the entity uses the asset, it generates economic benefits in the form of revenue.
The revenue generated by using the machine is taxable, any gain on disposal of the machine will be
taxable and any loss on disposal will be deductible for tax purposes. Therefore, as the future economic
benefits, in the form of revenue, are taxable, the future taxable amounts associated with the asset are
equal to the carrying amount of $50.
The following formula shows that the tax base of the plant is $60.
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Future
Tax base deductible
60 amounts
50 50
60
If you wish to explore this topic further you may now read Examples 2–5 in para. 7 of IAS 12.
➤➤Question 4.1
Calculate the tax base for the following assets:
(a) An item of inventory was purchased during the year for $250. The cost of the inventory for
both accounting and tax purposes is $250. The tax cost of the inventory will be included
in the determination of taxable profit (tax loss) as a deduction when the inventory is sold.
The income from the sale of inventory is taxable when the inventory is sold (i.e. on a cash basis).
274 | INCOME TAXES
(b) Trade receivables have a gross carrying amount of $250 and an allowance for doubtful debts
of $50 (i.e. the net trade receivable is $200). The related revenue has already been included
in taxable profit (tax loss). Doubtful debts will be deductible for tax purposes when the debt
is written off.
The tax base of liabilities

The tax base of a liability is ‘its carrying amount, less any amount that will be deductible for tax
purposes in respect of that liability in future periods. In the case of revenue which is received
in advance, the tax base of the resulting liability is its carrying amount, less any amount of the
revenue that will not be taxable in future periods’ (IAS 12, para. 8).
The formulas in Figure 4.4 may be helpful in performing the calculation to determine the tax base
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of a liability. (These formulas are based on the formula included in paras 5.2 and 5.3 of the now
superseded Australian Accounting Standard AASB 1020 Income Taxes.)
Figure 4.4: Tax base of a liability
Tax base of a
Future
liability that is not Carrying Future taxable
= – deductible +
revenue received amount amounts
amounts
in advance
Amount of
Tax base of
Carrying revenue not
revenue received = –
amount taxable
in advance
in the future
Source: Based on AASB (Australian Accounting Standards Board) 1999, AASB 1020 Income Taxes,
paras 5.2 and 5.3, pp. 25, 26, accessed November 2017, http://www.aasb.gov.au/admin/file/content102/
c3/AASB1020_12-99.pdf.
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For example, if a current liability with a carrying amount of $100 relates to expenses that will be
deductible for tax purposes when settled (i.e. when paid) and for which no taxable amounts arise,
the tax base of the current liability is nil.
Future
Tax base deductible
= amount – + amounts
Nil amounts
100 Nil
100
An example of revenue received in advance is interest revenue received in advance with a

carrying amount of $50. The related interest revenue is taxed on a cash basis (i.e. when received).
The tax base of the interest revenue received in advance is nil.
Carrying Amount of revenue

Tax base
= amount – not taxable in the future
Nil
50 50
The $50 is not taxable in the future because it was already taxed when the cash was received.
If you wish to explore this topic further, you may now read Examples 2–5 in para. 8 of IAS 12.
➤➤Question 4.2
Calculate the tax base for the following liabilities:
(a) Employee benefits have a carrying amount of $100. The employee benefits are deductible
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on a cash basis (i.e. when paid).
(b) A loan payable has a carrying amount of $250. The repayment of the loan will have no tax
consequences.
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(c) Revenue received in advance has a carrying amount of $400. The amount was taxed on a
cash basis (i.e. when received).
Step 2: Compare the tax base to the carrying amount

to determine temporary differences
A temporary difference is the ‘difference between the carrying amount of an asset or liability
in the statement of financial position and its tax base’ (IAS 12, para. 5).
Figure 4.5: Calculating the temporary difference

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Temporary Carrying
= – Tax base
difference amount
Therefore, temporary differences are identified by:

• comparing the carrying amount (in the statement of financial position) of each asset and
liability with its tax base
• identifying all items that have a carrying amount of $nil (in the statement of financial
position) but have a tax base. For example, research costs that are expensed when
incurred (i.e. no asset is recorded) but which are deductible for tax purposes in a
subsequent reporting period.
Using a worksheet format to present the statement of financial position and tax base will assist
in identifying taxable and deductible temporary differences.
This is illustrated in Table 4.5.

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Table 4.5: Illustrative worksheet extract
Taxable Deductible
temporary temporary
Assets and liabilities Carrying amount Tax base difference difference
Cash $10 000 $10 000 — —
Trade receivables $75 000 $80 000 — $5 000
Inventories $115 000 $115 000 — —
Plant and equipment $1 250 000 1 050 000 $200 000 —
Trade payables $60 000 $60 000 — —
Provisions $5 000 $nil — $5 000
Borrowings $750 000 $750 000 — —
The term temporary refers to the fact that such differences originate in a reporting period and
reverse in one or more later reporting periods. All temporary differences reverse over time.
For example, using the data included in Table 4.5, the deductible temporary difference of $5000
that arises in relation to the provision (i.e. as the carrying amount is greater than the tax base)
will reverse when the provision is settled.
If you wish to explore this topic further you may now read para. 17 of IAS 12, and Illustrative
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Examples (Part B of the Red Book) Part A (paras 1–11), Part B (paras 1–8) and Part C (paras 1–4)
of IAS 12.
Once temporary differences have been determined, the related deferred tax assets and deferred
tax liabilities can be calculated using the appropriate tax rate as shown in Figure 4.6.
Figure 4.6: Calculating deductible and taxable temporary differences
Deductible
Deferred
temporary × Tax rate =
tax asset
difference
Taxable
Deferred
temporary × Tax rate =
tax liability
difference
Table 4.6 summarises the relationship between the carrying amounts of assets and liabilities,
the tax base, and deferred tax assets and liabilities.
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Table 4.6: R
elationship between carrying amount, tax base and deferred tax
assets and liabilities
Statement of financial position
Asset Liability
Carrying amount > tax base 1 DTL †

4 DTA‡
Carrying amount < tax base 2 DTA‡ 5 DTL†
Carrying amount = tax base 3 None 6 None
†
Deferred tax liability arising from a taxable temporary difference.
‡
Deferred tax asset arising from a deductible temporary difference.
Source: Adapted from International Accounting Standards Committee 1994, Income Taxes,
background paper, para. 21, International Accounting Standards Committee, London.
We now explore these concepts further and begin by considering relationships 1 to 3 in Table 4.6,
the deferred tax amounts that arise from the relationship between the carrying amount of an asset
and its tax base.
Assets
To understand the rationale for the six combinations in Table 4.6, it is necessary to recall some
of the key concepts already discussed. The first three relationships outlined in Table 4.6 in regard
to assets are explained in Table 4.7.
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Table 4.7: A
ssets—relationship between carrying amount, tax base and deferred
tax assets and deferred tax liabilities
Assets
Is there a difference What are the future tax Do the future tax consequences
between the carrying consequences of recovering the give rise to a temporary
amount and the tax base? asset at its carrying amount? difference?
1. Carrying amount > The future taxable amounts from Yes. A taxable temporary difference
tax base recovery of the asset (through use arises.
or sale, discussed later) exceed
future deductible amounts. A deferred tax liability is recognised
for the future amounts of
tax payable.
2. Carrying amount < The future deductible amounts Yes. A deductible temporary
tax base exceed the future taxable difference arises.
amounts from recovery of the
asset (through use or sale). A deferred tax asset is recognised
tax recoverable.
3. Carrying amount = Either there are no future tax No temporary difference arises.
tax base consequences, or the future
deductible and future taxable No deferred tax asset or liability
amounts are equal. is recognised.

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The tax base of an asset is the ‘amount that will be deductible for tax purposes against any
taxable economic benefits that will flow to an entity when it recovers the carrying amount of
the asset’ (IAS 12, para. 7). When an entity uses an asset, it generates revenue and so recovers
the carrying amount of the item.
For example, if the taxable amount generated when the carrying amount of an asset is recovered
is $80 and the total depreciation that it will be able to deduct from this amount for tax purposes
is only $70, the entity will pay income tax in respect of taxable profit of $10 when it recovers
the carrying amount of the asset.
Therefore, a $3 deferred tax liability is recognised ($10 × 30%). A deferred tax liability is recognised
because recovery of the carrying amount of the asset will cause future tax payments to be greater
than they would be in the absence of the tax consequence.
This relationship can be viewed as follows:
Future
= + deductible –
amounts
Future
Tax base deductible
70 amounts
80 80
70
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Temporary Carrying
Tax base
difference = amount –
70
10 80
The carrying amount of the asset is greater than the tax base ($80 > $70).
Table 4.6 showed that this difference gives rise to a deferred tax liability (DTL). A DTL of
$3 ($10 × 30%) arises from a taxable temporary difference.
As an extension of this analysis, para. 7 of IAS 12 explains that where the future economic
benefits from recovering an asset are not taxable, the tax base of the asset is equal to its carrying
amount. In such circumstances, it follows that no deferred tax asset or liability is recognised.
For example, where the recovery of an asset such as a loan receivable does not have any future
tax consequences (i.e. the recovery of the principal is not taxable and there are no future
deductions), a deferred tax asset or liability does not arise.
If you wish to explore this topic further you may now read para. 7 of IAS 12 and refer to Example 5
(which is below para. 7). You may also wish to read paras 26(a), 26(b) and 26(d), which provide
examples of deductible temporary differences that result in deferred tax assets.
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➤➤Question 4.3
Refer to IAS 12, para. 7, Example 3.
Assume that the carrying amount of the trade receivables in the example is $80. The $80 is net
of expected doubtful debts of $20.
(a) Use the fundamental principle from para. 10 of IAS 12 to explain why a deferred tax asset
arises for this transaction.
(b) What is the amount of the temporary difference implied by your answer to Part (a) of this
question?
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(c) Apply the formulas for the tax base and a temporary difference to determine these amounts.
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(d) Explain which cell of Table 4.6 this amended example falls into.
If you wish to explore this topic further you may now read paras 15–17 of IAS 12, noting that for the
time being we will defer discussion of the exceptions mentioned in para. 15. You may also wish to
read items 4 and 5 of Part A of Illustrative Examples to IAS 12 (Part B of the Red Book).
Liabilities
The tax base of a liability is its carrying amount less future deductible amounts arising from the
liability. The tax consequence of a liability is the amount that is required to settle the obligation
that is deductible for tax purposes in the future period(s) in which settlement occurs. If settlement
of the amount of the liability is fully tax deductible in the future, the tax base will be $nil.
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Table 4.8 explains the second set of relationships outlined in Table 4.6 (numbers 4 to 6) in relation
to liabilities.
Table 4.8: L
iabilities—relationship between carrying amount, tax base and
deferred tax assets and deferred tax liabilities
Liabilities
Is there a difference What are the future tax Do the future tax consequences
between the carrying consequences of settling the give rise to a temporary
amount and the tax base? liability at its carrying amount? difference?
4. Carrying amount > There will be future deductible Yes. A deductible temporary
tax base benefits from settling the liability. difference arises.
A deferred tax asset is recognised

tax recoverable.
5. Carrying amount < There will be future taxable amounts Yes. A taxable temporary
tax base arising when the liability is settled. difference arises.
A deferred tax liability is

recognised for the future
amounts of tax payable.
6. Carrying amount = Either there are no future tax No temporary difference arises.
tax base consequences, or the future
deductible and future taxable No deferred tax asset or liability
amounts are equal. is recognised.

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The tax base of a liability is its carrying amount less future deductible amounts arising from
the liability.
For example, if a liability with a carrying amount of $100 is deductible for tax purposes at the
time of settlement, the liability has a tax base of $nil. Therefore, a deferred tax asset of
$30 is recognised ($100 × 30%).
A deferred tax asset is recognised because the settlement of the liability (at its carrying amount)
will cause future tax payments to be lower than they would have been in the absence of the
tax consequences.
➤➤Question 4.4
Part A (adapted from Part A of the Illustrative Examples to IAS 12)
(a) Using the basic principles from para. 10 of IAS 12, explain why a deferred tax liability should
be recognised in relation to the following scenarios:
Development costs
Development costs of $1000 that are recognised as an asset (i.e. capitalised) and will
be amortised to the P&L and OCI. The costs were deducted in determining taxable
profit when they were incurred (i.e. when the cash was paid).
Prepaid expenses
Prepaid expenses (recognised as an asset for accounting purposes) of $1000 that
have already been deducted on a cash basis (i.e. when paid) in determining the
taxable profit in a previous period.
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(b) Using the relevant formulas, determine the tax base and the temporary difference associated
with the items in Part A.
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Part B
A liability that was to be settled in units of a foreign currency was recognised in the reporting
currency financial statements of an entity at $100. Due to movements in the exchange rate
between the reporting currency and the foreign currency, the liability was remeasured by
$20 to $120.
The increase in the carrying amount of the liability was taken into account as a foreign exchange
loss when measuring accounting profit before tax for the current year. However, the loss is not
deductible against taxable profit until foreign currency is acquired to settle the liability in future.
(a) Use the fundamental principle from para. 10 of IAS 12 to explain why a deferred tax asset
arises for this transaction.
(b) What is the amount of the temporary difference implied by your answer to Part (a) of this
question?
(c) Use your answer to Part (b) of this question to derive the amount of the tax base.
(d) Apply the relevant formulas to derive the tax base and the temporary difference.
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If you wish to explore this topic further, you may now read Example 2 ‘Deferred tax assets and
liabilities’ under ‘Illustrative computations and presentations’ in Part C of the Illustrative Examples
in IAS 12 (Part B of the Red Book).
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Step 3: Measure deferred tax assets and deferred tax liabilities

Following the principles of IAS 12, the measurement of deferred tax assets and deferred
tax liabilities (which arise from deductible temporary differences and taxable temporary
differences) must reflect the expected manner of the recovery (settlement) of the underlying
asset (liability) and the tax rates that will apply in the period when the underlying asset (liability)
is realised (settled).
The relevant requirements of IAS 12 that give effect to this principle are as follows:
• ‘Deferred tax assets and liabilities shall be measured at the tax rates that are expected to
apply to the period when the asset is realised or the liability is settled, based on tax rates
(and tax laws) that have been enacted or substantively enacted by the end of the reporting
period’ (IAS 12, para. 47).
• ‘The measurement of deferred tax liabilities and deferred tax assets shall reflect the tax
consequences that would follow from the manner in which the entity expects, at the end
of the reporting period, to recover or settle the carrying amount of its assets and liabilities’
(IAS 12, para. 51).
IAS 12 does not define, or specify the conditions for, substantive enactment of tax rates.
Rather, IAS 12 (para. 48) states that:
Current and deferred tax assets and liabilities are usually measured using the tax rates (and tax
laws) that have been enacted. However, in some jurisdictions, announcements of tax rates (and
tax laws) by the government have the substantive effect of actual enactment, which may follow the
announcement by a period of several months. In these circumstances, tax assets and liabilities are
measured using the announced tax rate (and tax laws).
Accordingly, substantive enactment is determined by the legal framework of a jurisdiction.

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Further, para. 51A of IAS 12 explains that, in some tax jurisdictions, the amount of tax ultimately
payable or recoverable may depend on the manner in which an entity recovers (settles) the
carrying amount of an asset (liability). The manner of recovery (settlement) may affect either or
both of:
(a) the tax rate that is to be applied, or
(b) the tax base of the item.
In such cases, IAS 12 requires an entity to measure the deferred tax liability or deferred tax asset
using the tax rate and the tax base that are consistent with the expected manner of recovery
or settlement.
If you wish to explore this topic further you may now read paras 46 to 51A of IAS 12.
These concepts are illustrated in Examples 4.5 and 4.6.

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Example 4.5: The manner of recovery affects the tax rate

Entity D owns an item of plant and equipment that has a carrying amount of $100 000 and a tax base of
$60 000. In the tax jurisdiction of Entity D, a tax rate of 20 per cent applies if the plant and equipment
is sold, and a tax rate of 30 per cent applies to other income (i.e. if the asset is recovered through use).
Entity D would recognise a deferred tax liability of:
• $8000 ($40 000 × 20%) if it expects to sell the plant and equipment (without further use), or
• $12 000 ($40 000 × 30%) if it expects to recover the carrying amount of the plant and equipment
through use.
It is possible to have different tax consequences for an asset, depending on whether an asset is
expected to be held for use or sold without further use. Capital tax consequences such as those arising
from sale of plant and equipment (without further use) are often referred to as capital gains tax (CGT).
The CGT consequences may differ from revenue tax consequences—that is, the CGT cost base may
be different from the tax base of the asset if it is recovered through use. The CGT cost base may also
be different from the cost of the asset recognised for accounting purposes. Any difference between
the CGT cost base and the carrying amount of an asset affects the tax base of an item, and therefore
also has an impact on the calculation of deferred tax consequences.
Example 4.6: The manner of recovery affects the tax base

Entity F owns a building. The building was originally purchased by Entity F for $100 000. For accounting
purposes, the building is depreciated on a straight-line basis over five years and for tax purposes the
building is depreciated on a straight-line basis over four years. Tax depreciation is deductible each
year. The building has no residual value.
In the jurisdiction in which Entity F operates, the CGT cost base of the building (the amount deductible
against any taxable proceeds on sale) is $120 000.
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Scenario 1— asset to be held for use
At the end of year one, the entity expects to continue to use the asset for the next four years. At the
end of the year, Entity F would record the following balances:
Accounting Tax
$‘000 $‘000
Cost 100 100
Carrying amount/Tax base 80 75
Assuming that Entity F expects to continue to use the asset, at the end of year one, the tax base of the
building can be calculated as follows:
Future
= + deductible –
amounts
75 = 80 + 75 – 80
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Scenario 2— asset to be sold

At the end of year one, the entity expects to sell the asset in year three. At the end of the year, Entity F
would record the following balances (assuming that the depreciation deductions reduce the CGT cost
base of the asset):
Accounting Tax
$‘000 $‘000
Cost 100 120 (CGT cost base)
Depreciation 20 25
Carrying amount/Tax base 80 95
Assuming that Entity F expects to sell the asset, at the end of year one the tax base of the building
can be calculated as follows:
Future
= + deductible –
amounts
95 = 80 + 95 – 80
Discounting of deferred tax assets and deferred tax liabilities is not permitted
Deferred tax assets and deferred tax liabilities are expected to be recovered or settled at
dates in the future. It may seem appropriate that these amounts should be discounted to their
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present values at each reporting date. However, IAS 12 does not permit such discounting
(IAS 12, para. 53) for the reasons given in para. 54. Where the carrying amount of an asset or
liability is determined on a discounted basis, any temporary difference together with the related
deferred tax asset or deferred tax liability will be implicitly determined on a discounted basis.
The temporary difference, and therefore the deferred tax asset or deferred tax liability, is to be
determined on the basis of the discounted carrying amount of the asset or liability.
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Summary
The core principle of IAS 12 is that the financial statements should recognise the current and
future tax consequences of:
These current and future tax consequences are reflected in the financial statements
as ‘current tax liability, ‘deferred tax assets’, ‘deferred tax liabilities’ and ‘tax expense’
(refer back to Table 4.1 earlier in the module).
A taxable temporary difference is a temporary difference that will result in taxable amounts in
the future, when the carrying amount of an asset or liability is recovered or settled. As such,
future tax payments are larger, resulting in the recognition of a deferred tax liability.
A deductible temporary difference is a temporary difference that will result in deductible

amounts in the future, when the carrying amount of an asset or liability is recovered or settled.
As such, future tax payments are smaller, resulting in the recognition of a deferred tax asset.
A deferred tax liability arises when recovery or settlement of the carrying amount of an asset
or liability will have tax consequences that cause future tax payments to be larger than they
would have been in the absence of those tax consequences.
A deferred tax asset arises when recovery or settlement of the carrying amount of an asset
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or liability will have tax consequences that cause future tax payments to be smaller than they
would have been in the absence of those tax consequences.
Tax expense for a period comprises deferred tax expense (income) together with current
tax expense (income). Current tax expense (income) is the portion of current tax payable
(recoverable) in respect of the taxable profit (loss) that is recognised.
288 | INCOME TAXES
Part B: Recognition of deferred tax

Introduction
As outlined in Table 4.4 in Part A, there are four key steps required to recognise and measure
deferred tax. Part B of the module discusses Step 4.
IAS 12 requires an entity to recognise deferred tax assets and deferred tax liabilities, with certain
limited exceptions. These recognition rules (and limited recognition exceptions) implement the
recognition criteria of the Conceptual Framework in the specific context of the nature of deferred
tax assets and deferred tax liabilities.
IAS 12 prescribes separate recognition rules (and limited recognition exceptions) for deferred tax
assets and deferred tax liabilities.
Each will be discussed and considered separately.
Relevant paragraphs
To assist in achieving the objectives of Part B, you may wish to read the following paragraphs of
IAS 12. Where specified, you need to be able to apply these paragraphs as referenced in this
module:
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Subject Paragraphs
Initial recognition of an asset or liability 22(c)
Unused tax losses and unused tax credits 34–36
Reassessment of unrecognised deferred tax assets 37
Measurement 46–56
Recognition of current tax and deferred tax 57–60
Recognition of deferred tax liabilities

As explained in para. 15 of IAS 12, a deferred tax liability must be recognised for all taxable
temporary differences, except for certain limited exceptions discussed below.
As noted in the introduction to this Part, these recognition rules (and limited recognition
exceptions) implement the recognition criteria of the Conceptual Framework in the specific
context of the nature of deferred tax assets and deferred tax liabilities.
Under the IAS 12, para. 15 exceptions, deferred tax liabilities are not recognised when they
arise from:
(a) the initial recognition of goodwill; or
(b) the initial recognition of an asset or liability in a transaction which:
(i) is not a business combination; and
(ii) at the time of the transaction, affects neither accounting profit nor taxable profit (tax loss)
… (IAS 12, para. 15).
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Each of these two recognition exceptions is now discussed.
Initial recognition of goodwill arising from a business combination (IAS 12, para. 15(a))
Goodwill arising from a business combination is recognised and measured in accordance

with IFRS 3 Business Combinations.
Many taxation authorities do not allow reductions in the carrying amount of goodwill as a
deductible expense in determining taxable profit. Moreover, in such jurisdictions, the cost of
goodwill is often not deductible when a subsidiary disposes of its underlying business. In such
jurisdictions, goodwill has a tax base of nil. Any difference between the carrying amount of goodwill
and its tax base of nil is a taxable temporary difference. However, [IAS 12] does not permit the
recognition of the resulting deferred tax liability because goodwill is measured as a residual
and the recognition of the deferred tax liability would increase the carrying amount of goodwill
(IAS 12, para. 21).
Initial recognition of other assets or liabilities not in a business combination transaction

(IAS 12, para. 15(b))
A temporary difference may arise on initial recognition of an asset or liability if, for example,
part or all of the cost of an asset will not be deductible for tax purposes.
[I]f the transaction is not a business combination, and affects neither accounting profit nor
taxable profit, an entity would, in the absence of the exemption provided by paragraphs 15 and
24, recognise the resulting deferred tax liability or asset and adjust the carrying amount of the
asset or liability by the same amount. Such adjustments would make the financial statements less
transparent. Therefore, [IAS 12] does not permit an entity to recognise the resulting deferred tax
liability or asset, either on initial recognition or subsequently … Furthermore, an entity does not
recognise subsequent changes in the unrecognised deferred tax liability or asset as the asset is
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depreciated (IAS 12, para. 22(c)).
For example, an entity purchases an item of machinery for $100, however, the maximum deduction
available for items of machinery of this type has been limited by the taxation authority to $60 per
item of machinery.
As a result of the recognition exemption contained in para. 15(b), deferred tax liabilities are not
recognised and the journal entry to record the acquisition of the item of machinery is as follows:
$ $
Dr Machinery (property, plant and equipment) 100
Cr Cash/accounts payable 100
In the absence of the exemption contained in para. 15(b), the journal entry to record the
acquisition of the item of machinery would have been:
$ $
Dr Machinery (property, plant and equipment)
(Cost $100 + Deferred tax ($40 × 30%)) 112
Cr Deferred tax liability ($40 × 30%) 12
Cr Cash/accounts payable 100
IAS 12, para. 22(c) does not permit an entity to recognise the resulting deferred tax liability or
asset, either on initial recognition or subsequently, as such adjustments would make the financial
statements less transparent.
If you wish to explore this topic further you may now read para. 22(c) of IAS 12, including the
related example.
290 | INCOME TAXES
Paragraph 39 of IAS 12 also includes an exemption for a deferred tax liability for taxable
temporary differences associated with investments in subsidiaries, branches and associates,
and interests in joint arrangements in certain circumstances. Understanding this exemption is
outside the scope of this module.
Recognition of deferred tax assets

Deferred tax assets may arise from:
• deductible temporary differences
• unused tax losses and unused tax credits.
As explained in para. 24 of IAS 12, a deferred tax asset must be recognised for all deductible
temporary differences to the extent that it is probable that taxable profit will be available
against which the deductible temporary difference can be utilised, except for certain limited
exclusions.
Similarly, para. 34 of IAS 12 explains that a deferred tax asset shall be recognised for the carry-
forward of unused tax losses and unused tax credits to the extent that it is probable that future
taxable profit will be available against which the unused tax losses and unused tax credits can
be utilised.
These recognition rules (and limited recognition exceptions) are discussed below.
Recognition rules for deductible temporary differences

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When applying the recognition criteria to deferred tax assets arising from deductible temporary
differences (IAS 12, para. 24) consideration must be given to:
• whether any of the specific recognition exceptions apply
• the probability that taxable profit will be available against which the deductible temporary
difference can be utilised.
Each of these matters is discussed separately below.
Recognition exceptions
In specified circumstances, certain deductible temporary differences are exempt from being
recognised as deferred tax assets.
Deferred tax assets are not recognised when they arise from the initial recognition of an asset
or liability in a transaction that:
(a) is not a business combination; and
(b) at the time of the transaction, affects neither accounting profit nor taxable profit (tax loss)
(IAS 12, para. 24).
For example, an entity purchases an asset at a cost of $1000. For tax purposes, on initial
recognition, the asset has a tax base of $1200 (under the relevant tax laws). As a result of the
recognition exemption contained in para. 24, the entity does not recognise a deferred tax asset
for the difference between the initial carrying amount of the asset and the tax base.
Study guide | 291
If you wish to explore this topic further you may now read para. 33 of IAS 12, including the
related example.
Paragraph 44 of IAS 12 also includes an exemption for a deferred tax asset for deductible
temporary differences associated with investments in subsidiaries, branches and associates,
and interests in joint arrangements in certain circumstances. Understanding this exemption is
outside the scope of this module.
Application of the probable criterion

Deferred tax assets arising from deductible temporary differences are recognised only when
it is probable that future economic benefit associated with the item will flow to the entity.
Deductible temporary differences reverse (i.e. the deferred tax asset is recovered) when the
carrying amounts of assets or liabilities are recovered or settled and result in deductions in
determining taxable amounts in future periods.
The benefits of a deferred tax asset are probable of recovery only if it is probable that the entity
will earn sufficient taxable profits against which the temporary differences can be deducted
(IAS 12, paras 24 and 27).
IAS 12 does not include a definition of ‘probable’. Guidance on the generally accepted meaning
of ‘probable’ is contained in IAS 37 Provisions, Contingent Liabilities and Contingent Assets,
which states that:
… an outflow of resources or other event is regarded as probable if the event is more likely than
not to occur, that is, the probability that the event will occur is greater than the probability that it
will not … (IAS 37, para. 23).
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IAS 37 indicates that the definition in para. 23 is not necessarily applicable to other standards.
However, it is reasonable to use this definition to assist in understanding the application of
paras 24 and 27 of IAS 12.
If you wish to explore this topic further you may now read paras 24, 25 and 27 of IAS 12 to review
the deferred tax asset recognition requirements.
Paragraph 28 of IAS 12 explains that a primary source of taxable profit is the reversal of taxable
temporary differences. When a taxable temporary difference reverses, taxable amounts arise and
are included in taxable profit. A deductible temporary difference can then be used against the
resulting taxable profit.
Further guidance is contained in para. 29 of IAS 12, which explains that when there are insufficient
taxable temporary differences, the deferred tax asset is recognised to the extent that:
• it is probable that there will be other taxable profit, after allowing for future taxable profit
required in order to utilise future deductible temporary differences, or
• the entity can create taxable profit by using tax planning opportunities.
Tax planning opportunities are ‘actions that the entity would take to create or increase
taxable income in a particular period before the expiry of a tax loss or tax credit carry-forward’
(IAS 12, para. 30).
This relationship is shown diagrammatically in Figure 4.7.

292 | INCOME TAXES
Figure 4.7: Tax planning relationships

Yes
Are there sufficient taxable temporary differences?
No
Yes
Is it probable that there will be other taxable profit available?
No
Yes
Can the entity create taxable profit by using tax planning opportunities?
No
Recognise deferred
Do NOT recognise deferred tax asset tax asset
Accounting treatment for an entity with a history of tax losses is discussed later in this module.
If you wish to explore this topic further you may now read paras 28–31 to confirm your understanding
of when the probability recognition criterion is satisfied for deferred tax assets.
Examples 4.7 and 4.8 illustrate how the ‘probability criterion’ would be satisfied for the
recognition of the deductible temporary difference as a deferred tax asset.
Example 4.7: Probability of the future utilisation of deductible

temporary differences (scenario 1)
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The records of HIJ Investments PLC as at 31 December 20X9 show the following:
Warranty obligations—deductible temporary difference

• A deductible temporary difference of $60 000 relating to warranty obligations, which was expected
to reverse in the future reporting periods, as follows:
– $20 000 in 20Y0 (i.e. leaving a remaining balance of the deductible temporary difference
of $40 000)
– $40 000 in 20Y1 (i.e. leaving a $nil remaining balance of the deductible temporary difference).
Receivables—taxable temporary difference

• A deferred tax liability of $30 000 relating to a taxable temporary difference of $100 000.
The temporary difference relates to a receivable that was recognised in the measurement of
accounting profit in the year ended 31 December 20X9. The receivable relates to the sale of widgets
for which sales are recognised as a receivable for accounting purposes when the revenue is earned,
and are taxable when the cash is received.
It was expected that this taxable temporary difference of $100 000 would reverse on receipt of
cash in future reporting periods, as follows:
– $45 000 in 20Y0 (i.e. leaving a remaining deferred tax liability balance of $16 500 ($55 000 × 30%))
– $55 000 in 20Y1 (i.e. leaving a $nil remaining deferred tax liability balance).
• There were no other transactions in 20X9, 20Y0 and 20Y1.
• Taxable profit for the year ended 31 December 20X9 was $nil.
• The entity does not have a history of losses.
Recognising a deferred tax asset

The deductible temporary difference originating during the period ended 31 December 20X9 gives
rise to a deferred tax asset of $18 000 ($60 000 × 30%). Applying the requirements of para. 24 of IAS 12,
this deferred tax asset should be recognised in full if ‘it is probable that taxable profit will be available
against which the deductible temporary difference can be utilised’.
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20X9: Taxable temporary 20Y0: Future taxable profit 20Y1: Future taxable profit
difference on reversal of taxable on reversal of taxable
temporary difference: temporary difference:
$100 000 $45 000 $55 000
20X9: Deductible temporary 20Y0: Amount deductible on 20Y1: Amount deductible on

difference reversal of deductible reversal of deductible
$60 000 $20 000 $40 000
The analysis here shows that the expected reversals of the taxable temporary difference in years 20Y0
($45 000) and 20Y1 ($55 000) are greater than the expected reversals of the deductible temporary
difference in each of these years ($20 000 and $40 000 respectively).
This means that the expected taxable profits in each of 20Y0 and 20Y1, arising from the reversal of
the taxable temporary difference, are sufficient to absorb the amounts of the deductible temporary
difference that reverses in each period. As a consequence, HIJ Investments PLC should recognise a
deferred tax asset of $18 000 ($60 000 × 30%) as at 31 December 20X9.
Using the language of para. 28(a) of IAS 12, it is probable that sufficient taxable profit will be available,
because there are ‘sufficient taxable temporary differences relating to the same taxation authority and
the same taxable entity, which are expected to reverse in the same period as the expected reversal
of the deductible temporary difference’.
Example 4.8: Probability of the future utilisation of deductible

temporary differences (scenario 2)
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Participants should note that this example adopts very similar data to that used in Example 4.7.
The key points of difference are that the data for this example assumes the reversal of the deductible
temporary difference in full in 20Y0 and additional $55 000 expected future deductible expenses in
20Y1. As a result, the assessment illustrated in this example concludes that the probability criterion is
not satisfied and, accordingly, the deferred tax asset is not recognised. Participants should take care to
note these differences when comparing the analysis and conclusions of Example 4.7 and Example 4.8.
The records of JKL Investments PLC as at 31 December 20X9 show the following:
Warranty obligations—deductible temporary difference

• A deductible temporary difference of $60 000 relating to warranty obligations, which was expected
to reverse in full in 20Y0 (i.e. leaving a $nil remaining balance of the deductible temporary
difference).
Receivables—taxable temporary difference

• A deferred tax liability of $30 000 relating to a taxable temporary difference of $100 000.
The temporary difference relates to a receivable that was recognised in the measurement of
accounting profit in the year ended 31 December 20X9. The receivable relates to the sale of widgets
for which sales are recognised as a receivable for accounting purposes when the revenue is earned,
and are taxable when the cash is received.
It was expected that the temporary difference would reverse on receipt of cash in future reporting
periods, as follows:
– $45 000 in 20Y0 (i.e. leaving a remaining deferred tax liability balance of $16 500)
– $55 000 in 20Y1 (i.e. leaving a $nil remaining deferred tax liability balance).
• Other expenses that were expected to be deductible for tax purposes during 20Y1 were $55 000.
• There were no other transactions in 20X9, 20Y0 and 20Y1.
• Taxable profit for the year ended 31 December 20X9 was $nil.
• Tax losses can be carried forward for offset against future taxable income for only one year.
The carry-back of tax losses is not permitted.
• JKL Investments PLC does not have a history of losses.
294 | INCOME TAXES
Recognising a deferred tax asset

In this case, the deductible temporary difference of $60 000 is expected to reverse in full in 20Y0.
However, the amount of taxable profit arising from the reversal of the taxable temporary difference in
20Y0 is only $45 000, and the reversal of the taxable temporary differences in 20Y1 does not exceed
the other deductible expenses in 20Y1 (i.e. taxable profit for 20Y1 is expected to be $nil). Therefore,
the expected taxable profit in 20Y0 and 20Y1 is not sufficient to absorb the full amount of the deductible
temporary difference.
On this basis, para. 24 of IAS 12 has not been satisfied.
The analysis shown in the next graphic confirms that, since there were no other transactions during
20X9, 20Y0 or 20Y1, there are no taxable profits in excess of those arising from reversal of the taxable
temporary difference against which the deductible temporary difference can be used.
20X9: Taxable temporary 20Y0: Future taxable profit 20Y1: Future taxable profit
difference on reversal of taxable on reversal of taxable
$100 000 $45 000 $55 000
20X9: Deductible temporary 20Y0: Amount deductible on 20Y1: Other deductible

difference reversal of deductible expenses
temporary difference:
$60 000 $60 000 $55 000
As only $45 000 of the deductible temporary difference can be used against the taxable temporary
difference in 20Y0, and taxable profit is expected to be $nil in 20Y1, the amount of the deferred tax asset
that can be recognised at 31 December 20X9 is restricted to $13 500 ($45 000 × 30%), leaving $15 000
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of the deductible temporary difference unrecognised at 31 December 20X9.
➤➤Question 4.5
(a) Using the data and analysis in Example 4.8, present the income tax journal entries for
31 December 20X9.
Study guide | 295
(b) Assume that the tax legislation allows for the carrying back of tax losses for deduction from
taxable income of the three years before the year of the tax loss. Explain whether or not
you would recognise the full amount of the deferred tax asset as at 31 December 20X9.
Recognition of deferred tax

Deferred tax arises from the recognition and movement in deferred tax assets and deferred
tax liabilities.
As discussed in Part A of this module (in relation to the recognition of current tax) the principle
adopted by IAS 12 (para. 12) to account for the tax effects of a transaction or other event
(e.g. the recognition of current tax and deferred tax) is that accounting for tax should be
consistent with the accounting treatment of the transaction or event itself.
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For example, deferred tax is recognised in P&L (i.e. included in the amount of tax expense
(tax income) for the reporting period) to the extent that it relates to items of income and expense
recognised in P&L for the reporting period.
However, deferred tax can also relate to gains or losses recognised in OCI, items recognised
directly in equity or business combination transactions. In these circumstances, deferred tax
is recognised in OCI, directly in equity or as part of accounting for the business combination,
as appropriate, to the extent that it relates to such items or transactions.
Paragraphs 58 to 68C of IAS 12 implement this principle, with the main requirements contained
in para. 58, as follows:
Current and deferred tax shall be recognised as income or an expense and included in profit or loss
for the period, except to the extent that the tax arises from:
(a) a transaction or event which is recognised, in the same or a different period, outside profit or
loss, either in other comprehensive income or directly in equity …; or
(b) a business combination (other than the acquisition by an investment entity, as defined in
IFRS 10 Consolidated Financial Statements, of a subsidiary that is required to be measured at
fair value through profit or loss) (IAS 12, para. 58).
Further para. 61A notes that current tax and deferred tax shall be recognised outside of P&L
if the tax relates to items that are also recognised outside of the P&L in the same or different
period. Therefore, current tax and deferred tax that relate to such items are recognised:
• in OCI where the item is recognised in OCI
• directly in equity where the item is recognised directly in equity (IAS 12, para. 61A).
The recognition of deferred tax outside of P&L will be discussed further in Part C of this module.
(Business combinations and investment entities are covered in Module 5.)
296 | INCOME TAXES
➤➤Question 4.6
Lowsales Ltd has the following extract from its statement of financial position as at 30 June 20X1:
$
Cash assets 97 000
Accounts receivable (net) 234 000
Prepaid rent 4 000
Inventory 228 000
Equipment (net) 48 000
Total assets 611 000
Accounts payable 67 000

Revenue received in advance 18 000
Bank loan 100 000
Foreign currency loan payable 32 000
Employee benefits liability 65 000
Total liabilities 282 000
The following information is relevant for Lowsales Ltd:
1. Revenue received in advance is recognised in the statement of financial position of Lowsales
Ltd and will be recognised in the P&L and OCI in a later reporting period (i.e. as the revenue
is earned). It is included in taxable profit in 20X1 (i.e. it is taxed on a cash basis).
2. The employee benefits liability increases with additional employee expenses and decreases
when the liability is paid. Lowsales Ltd receives a tax deduction when employee benefits
are paid.
3. For tax purposes, deductions can only be claimed for bad debts written off. At 30 June 20X1,
the allowance for doubtful debts was $11 000 and the allowance had increased by $5000.
The revenue relating to the accounts receivable has already been taxed.
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4. The equipment was originally purchased four years ago for $80 000. The equipment is being
depreciated for tax purposes over eight years and for accounting purposes over 10 years.
5. The foreign currency loan payable was originally drawn down at $33 000. The $1000 foreign
exchange gain included in the statement of P&L and OCI is not included in taxable profit
until the loan is settled.
6. Prepaid rent has increased by $2000 during the year. This additional outlay can be claimed
as a tax deduction as incurred (i.e. when it is paid).
7. There are no future tax consequences associated with the cash, accounts payable or inventory
assets.
Assume that Lowsales has an opening deferred tax asset balance of $16 200 and opening deferred
tax liability balance of $2400. Lowsales’ taxable profit for the financial year ending 30 June 20X1
is $331 000. Assume a tax rate of 30 per cent.
(a) Calculate the relevant tax bases for assets and liabilities for Lowsales for the financial year
ended 30 June 20X1.
(b) Prepare the deferred tax worksheet (deferred tax assets, liabilities and expense) for Lowsales
for the financial year ended 30 June 20X1.
(c) Prepare the income tax journal entry for Lowsales for the financial year ended 30 June 20X1.
(The format of the deferred tax worksheet used in Question 4.6 is an adaptation of the deferred
tax worksheet in Part B of IAS 12.)
Study guide | 297
Recognition rules for unused tax losses and unused tax credits
Deferred tax assets also arise when the taxation legislation within a particular jurisdiction allows
an entity to carry forward unused tax losses and tax credits for use against later years’ profits—
that is, to use prior period tax losses and tax credits to reduce tax payable in future periods.
The taxation legislation usually contains several provisions and exceptions, which would need
to be carefully considered to determine the extent to which unused tax losses and unused tax
credits may be carried forward to utilise against future taxable profit.
Deferred tax assets arising from unused tax losses and unused tax credits should be recognised
on the same basis as other deferred tax assets. That is, to the extent that ‘it is probable that
future taxable profit will be available against which the unused tax losses and unused tax credits
can be utilised’ (IAS 12, para. 34).
When applying the probability criterion to unused tax losses or tax credits, IAS 12 states that the
existence of unused tax losses is strong evidence that future taxable profit may not be available.
In this regard, IAS 12 explains further that ‘when an entity has a history of recent losses, the entity
recognises a deferred tax asset arising from unused tax losses or tax credits only to the extent
that the entity has sufficient taxable temporary differences or there is convincing other evidence
that sufficient taxable profit will be available against which the unused tax losses or unused tax
credits can be utilised by the entity’ (IAS 12, para. 35).
When assessing the probability that taxable profit will be available against which the unused
tax losses or unused tax credits can be utilised, IAS 12 requires that an entity considers the
following criteria:
(a) whether the entity has sufficient taxable temporary differences relating to the same taxation
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authority and the same taxable entity, which will result in taxable amounts against which the
unused tax losses or unused tax credits can be utilised before they expire;
(b) whether it is probable that the entity will have taxable profits before the unused tax losses
or unused tax credits expire;
(c) whether the unused tax losses result from identifiable causes which are unlikely to recur; and
(d) whether tax planning opportunities (see paragraph 30) are available to the entity that will create
taxable profit in the period in which the unused tax losses or unused tax credits can be utilised.
To the extent that it is not probable that taxable profit will be available against which the
unused tax losses or unused tax credits can be utilised, the deferred tax asset is not recognised
(IAS 12, para. 36).
Examples 4.9 and 4.10 use two different scenarios to illustrate the assessment of whether it is
probable there will be sufficient future taxable profit available to utilise unused tax losses.
298 | INCOME TAXES
Example 4.9: A
ssessing the probability of future utilisation
of unused tax losses (scenario 1)
This example uses the same facts outlined for Example 4.8, plus the following additional information.
Assume that JKL Investment’s taxable profit for 20Y0, and expected taxable profit for 20Y1, are as set
out in the accompanying table.
Taxable profit for JKL Investments

Actual Expected
taxable income taxable income
20Y0 20Y1
$ $
Receivable 45 000 55 000
Allowable deductions
Settlement of warranty obligations (60 000 )
Other (55 000 )
Taxable income (loss) (15 000 ) nil
The table shows a tax loss for 20Y0 of $15 000. This tax loss is associated with the reversal of the
taxable temporary difference and the reversal of the deductible temporary difference that arose in
20X9 (as outlined in Example 4.8).
As outlined in Example 4.8, this example assumes that tax losses can be carried forward for offset
against future taxable income for only one year, and carry-back of tax losses is not permitted.
On this basis, the $15 000 tax loss in 20Y0 can only be recognised as a deferred tax asset at 31 December
20Y0 to the extent that it is probable that taxable profit will be available during the one-year tax loss
carry‑forward period.
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However, as illustrated by the table, the expected taxable profit for 20Y1 is $nil. Although the tax
loss arising from the deferred tax asset is available for carrying forward, there is insufficient expected
taxable profit during the carry-forward period against which to use the tax loss.
Therefore, the $15 000 tax loss cannot be recognised as a deferred tax asset at 31 December 20Y0.
Example 4.10: A
ssessing the probability of future utilisation
of unused tax losses (scenario 2)
Use the same assumptions as Example 4.9, but now assume that there are no ‘other tax deductible
expenses’ in 20Y1.
Given the amended assumptions for JKL Investments, taxable profit for 20Y0, and expected taxable
profit for 20Y1, are as set out in the accompanying table.
Taxable profit for JKL Investments

Actual Expected
taxable income taxable income
20Y0 20Y1
$ $
Receivable 45 000 55 000
Allowable deductions
Settlement of warranty obligations (60 000 ) —
Taxable profit (loss) (15 000 ) 55 000
Less: Credit for tax loss carried forward (15 000 )
Taxable profit after carrying forward tax losses 40 000
Study guide | 299
This table shows a tax loss for 20Y0 of $15 000. This tax loss is associated with the reversal of the
taxable temporary difference and the reversal of the deductible temporary difference that arose in
20X9 (as outlined in Example 4.8).
As outlined in Example 4.8, this example assumes that tax losses can be carried forward for offset
against future taxable income for only one year, and carry-back of tax losses is not permitted.
On this basis, the $15 000 tax loss in 20Y0 can only be recognised as a deferred tax asset at 31 December
20Y0 to the extent that it is probable that taxable profit will be available during the one-year tax loss
carry‑forward period.
As illustrated in the table for this scenario, the expected taxable profit for 20Y1 is $55 000 and this is
sufficient to use the $15 000 tax loss arising from the deferred tax asset in 20Y0. Therefore, the $15 000
tax loss should be recognised as a deferred tax asset at 31 December 20Y0.
If you wish to explore this topic further you may now read paras 34 to 36 of IAS 12.
Recoupment of tax losses

The previous section of this module discussed the recognition of tax losses as a deferred tax
asset in the year in which the tax loss was generated.
This section discusses the accounting treatment of the recoupment of tax losses (i.e. utilising
carry-forward tax losses to reduce taxable profit in subsequent reporting periods).
The core principle of IAS 12 is that the accounting treatment of the recoupment of tax losses
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must be consistent with the accounting treatment applied in the tax loss period. More specifically,
the accounting treatment of the recoupment of tax losses is dependent on whether or not the tax
losses were recognised as a deferred tax asset.
The practical application of this core principle is that when tax losses are recouped, the benefit
from the recoupment of those losses is allocated:
• first to tax losses for which no deferred tax asset was previously recognised (which, in effect,
results in the recognition of tax income)
• second to tax losses for which a deferred tax asset was previously recognised (which, in effect,
results in the reduction of the previously recognised deferred tax asset).
These principles are illustrated in Table 4.9 and in Examples 4.11 and 4.12.
300 | INCOME TAXES
Table 4.9: Recognising and recouping a deferred tax asset
Pro forma journal entry

Probability criterion for recoupment of the
satisfied? Recognition Recoupment temporary differences
Probability criterion for A deferred tax asset The DTA is realised Dr Deferred tax expense
recognition is satisfied (DTA) is recognised when the tax losses are Cr DTA
(either by taxable in the loss year recouped. Therefore,
temporary differences the benefit of the
or other sources) tax losses recouped,
the savings in the
See Example 4.11 outflow of resources
for tax payments,
is recognised as a
reduction in the DTA.
Probability criterion A DTA is not The benefit of the tax Dr Deferred tax expense
for recognition is recognised in the losses recouped is a Cr Current tax income†
not satisfied loss year, as it is not reduction in the entity’s
probable that there tax payments. Since a
See Example 4.12 would be sufficient DTA was not initially
taxable profit against recognised, the saving
which the unused in the outflows for tax
tax losses could cannot be recognised as
be utilised. a reduction in an asset.
However, the reduction
in the liability for tax
satisfies the definition
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of income set out in the

Conceptual Framework.
Therefore, the benefit of
the tax losses recouped
is recognised as current
tax income.
†
This journal entry is the net of two journal entries:
Dr DTA
Cr Current tax income
Initial recognition of DTA
Dr Deferred tax expense

Cr DTA
Subsequent realisation of DTA
As both of these journal entries would be recognised in the same period, there is no requirement
to separately recognise the Dr and Cr the DTA.

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Example 4.11: Probability recognition criterion satisfied

The following assumptions are applicable for TL Ltd:
(a) The tax return of TL Ltd for the year ended 30 June 20X9 revealed a tax loss of $60 000.
(b) Tax losses were available for carry-forward for an indefinite period for use against future taxable
profit.
(c) As at 30 June 20X9, sufficient taxable temporary differences existed against which the $60 000 tax
loss can be utilised.
(d) Other than the reversal of the existing taxable temporary differences (noted in point (c), above),
as at 30 June 20X9, there was no convincing evidence that other taxable profit would be available
in the future.
(e) Taxable profit for the year ended 30 June 20Y0 was $100 000.
(f) There were no movements in temporary differences during the years ended 30 June 20X9 and
30 June 20Y0.
(g) The tax rate is 30 per cent.
(h) Reconciliations between accounting profit before tax and taxable profit (loss) for the years ended
30 June 20X9 and 30 June 20Y0 were as follows:
Year ended Year ended

30 June 20X9 30 June 20Y0
$ $
Accounting profit (loss) before tax (65 000 ) 110 000
Adjustments for movements in non-temporary
differences and excluded temporary differences
Statutory fines for breaching environmental laws 5 000
Exempt dividends (10 000 )
Adjustments for movements in — —
temporary differences
Taxable profit (loss) before utilising tax losses (60 000 ) 100 000
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Tax losses recouped (60 000 )
Taxable profit (loss) after utilising tax losses (60 000 ) 40 000
Tax loss reporting period ended 30 June 20X9

As at 30 June 20X9, it was probable that there would be sufficient taxable profits arising from the
reversal of existing taxable temporary differences during the tax loss carry-forward period. Paragraph 34
of IAS 12 allows the entity to recognise a deferred tax asset of $18 000 ($60 000 × 30%) on that date.
The journal entry required is:
30 June 20X9 $ $
Deferred tax asset 18 000
Current tax income 18 000
The credit entry is against ‘current tax income’ rather than ‘deferred tax income’, as the tax income
arises as a consequence of the tax loss from the calculation of current tax payable (refundable).
Recoupment period ended 30 June 20Y0

During the year ended 30 June 20Y0, taxable profit (loss) before utilising tax losses was $100 000.
Consequently, the 20X9 tax loss of $60 000 was recouped in full.
Recall that when tax losses are recouped, the benefit from the recoupment of those losses is allocated:
• first to tax losses for which no deferred tax asset was previously recognised
• second to tax losses for which a deferred tax asset was previously recognised.
302 | INCOME TAXES
In this example, a deferred tax asset was previously recognised for the whole of the tax losses that
were incurred during the year ended 30 June 20X9. Since the deferred tax asset has been realised
in full, $18 000 is credited to the deferred tax asset balance. The corresponding debit is to deferred
tax expense.
Taxable profit for the period, after taking into account the tax losses recouped, was $40 000, giving rise
to tax payable and current income tax expense of $12 000 ($40 000 × 30%).
The journal entries required are shown below:
• Tax losses recouped were $60 000, which would give rise to the following entry:
$ $
Deferred tax expense 18 000
• Taxable profit was $40 000, which would give rise to the following entry:
$ $
Current tax expense 12 000
Tax payable 12 000
Combining these two entries would give:

$ $
Tax expense 30 000
Tax payable 12 000
(As explained in Part A of this module, and illustrated in Figure 4.1, ‘tax expense’ is the sum of ‘current
tax’ and ‘deferred tax’ recognised in the P&L for the period. In this example, tax expense of $30 000
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(illustrated by combining the two entries) is the sum of deferred tax expense of $18 000 (from the first
entry) and current tax expense of $12 000 (from the second entry).)
Confirm that the total tax expense over the two-year period was $12 000. Over the two-year period,
the total of both accounting profit before tax and taxable profit was $40 000 ($100 000 – $60 000).
At a tax rate of 30 per cent, total tax expense over the two-year period should be $12 000.
Example 4.12: Probability recognition criterion not satisfied

This example uses the same facts outlined in Example 4.11, but assumes there is no convincing other
evidence that there would be sufficient taxable profits arising from other sources during the tax loss
carry-forward period.
Tax loss reporting period ended 30 June 20X9

As at 30 June 20X9 there were no taxable temporary differences against which the tax losses could be
used. Nor was there convincing other evidence that there would be sufficient taxable profits arising
from other sources during the tax loss carry-forward period. Therefore, under para. 34 of IAS 12,
the entity is unable to recognise a deferred tax asset as at 30 June 20X9.
Recoupment period ended 30 June 20Y0

During the year ended 30 June 20Y0, taxable profit (loss) before utilising tax losses was $100 000.
As the probability criterion for recognition of the deferred tax asset was not satisfied for the reporting
period ended 30 June 20X9, the entity recognises the benefit of any tax losses recouped as current
tax income. In the present example, a deferred tax asset was not recognised in the loss year.
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The journal entries are:
• Tax losses recouped of $60 000, which would give rise to the following entry:
$ $
Current tax income 18 000
• Taxable profit of $40 000, which would give rise to the following entry:
$ $
Combining these two entries would give:

$ $
Tax expense 12 000
Tax payable 12 000
(As explained in Part A of this module, and illustrated in Figure 4.1, ‘tax expense’ is the sum of ‘current
tax’ and ‘deferred tax’ recognised in the P&L for the period. In this example, tax expense of $12 000
(illustrated by combining the two entries) is the sum of deferred tax expense of $18 000 (from the first
entry), current tax income of $18 000 (from the first entry) and current tax expense of $12 000 (from
the second entry).)
Question 4.7 deals with a more complicated set of circumstances than those discussed in
Examples 4.11 and 4.12.
➤➤Question 4.7
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Note to candidates: This is a very challenging question. It is recommended that you have a good
understanding of the concepts discussed earlier in this module before attempting this question.
Using the following data, prepare tax-effect journal entries for Bayside Ltd for each of the years
ended 30 June 20X9, 30 June 20Y0 and 30 June 20Y1.
Prior to the beginning of the 20X9 financial year, Bayside Ltd had recognised a deferred tax liability
of $600 relating to a taxable temporary difference of $2000. The taxable temporary difference
is the cumulative difference between the amounts of accelerated depreciation deducted for tax
purposes and the amounts of straight-line depreciation expense for accounting purposes.
Summary of key amounts for the years ended 30 June 20X9 – 30 June 20Y1:
Year ended Year ended Year ended
30 June 30 June 30 June
20X9 20Y0 20Y1
$ $ $
(1 ) (2 ) (3 )
1. Accounting profit (loss) before income tax (6 000 ) 2 800 7 700
2. Deduct additional tax depreciation (1 000 ) (800 ) (700 )
3. Taxable profit (loss) before utilising
unused tax losses (7 000 ) 2 000 7 000
4. Less tax losses recouped this period 0 2 000 5 000
5. Taxable profit (loss) (7 000 ) 0 2 000
6. Current tax payable 0 0 600
304 | INCOME TAXES
The following key items are provided in the table:

• Bayside Ltd incurred a tax loss of $7000 during the period ended 30 June 20X9 (row 3 of
column 1).
• The differences between accounting profit (loss) before income tax and taxable profit (loss)
arise from using accelerated depreciation for tax purposes and straight-line depreciation for
accounting purposes. The extra amounts of tax depreciation allowed each year are deducted
in row 2.
• Row 3 of column 2 shows that for the year ended 30 June 20Y0, taxable profit, before utilising
unused tax losses, was $2000. The corresponding amount for the year ended 30 June 20Y1
was $7000.
• The taxable temporary differences that arose from the additional tax depreciation, shown in
row 2 for each of the three years, were expected to reverse before the end of the seven-year
tax loss carry-forward period that commenced on 30 June 20X9.
For 30 June 20X9 and 30 June 20Y0, Bayside was unable to establish that it was probable that
there would be future taxable profits in excess of taxable profits from the reversal of taxable
temporary differences.
The taxation legislation does not provide for the carry-back of tax losses.
The tax rate is 30 per cent.
Reassessment of the carrying amounts of deferred tax assets

and liabilities
IAS 12 contains several requirements relating to the reassessment of the carrying amounts of
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deferred tax assets and liabilities.
First, ‘[t]he entity recognises a previously unrecognised deferred tax asset to the extent that it
has become probable that future taxable profit will allow the deferred tax asset to be recovered’
(IAS 12, para. 37).
Second, IAS 12, para. 56 explains that the carrying amount of a deferred tax asset should be
reduced to the extent that it is no longer probable that there will be sufficient taxable profit
to allow realisation of the asset. A reduction is reversed to the extent that it has subsequently
become probable that there will be sufficient taxable profit to allow realisation of the asset.
Paragraph 60 of IAS 12 states that the carrying amount of a deferred tax asset may change
following a reassessment of the expected recoverability of the item. Paragraph 60 also states that
the carrying amounts of deferred tax assets and deferred tax liabilities may change following:
(a) a change in tax rates or tax laws;
(b) a reassessment of the recoverability of deferred tax assets; or
(c) a change in the expected manner of recovery of an asset (IAS 12, para. 60).
When deferred tax balances change, deferred tax arises. The resulting deferred tax should be
recognised in P&L, unless it relates to items previously recognised in OCI or directly charged
or credited to equity.
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➤➤Question 4.8
An entity is finalising its financial statements for the year ended 30 June 20Y0. Before 30 June
20Y0, the government announced that the tax rate was to be amended from 40 per cent to
45 per cent of taxable profit from 30 September 20Y0.
The legislation to amend the tax rate has not yet been approved by the legislature. However,
the government has a significant majority and it is usual, in the tax jurisdiction concerned,
to regard an announcement of a change in the tax rate as having the substantive effect of actual
enactment (i.e. it is substantively enacted).
After performing the income tax calculations at the rate of 40 per cent, the entity has the following
temporary differences and deferred tax asset and deferred tax liability balances:
Aggregate deductible temporary differences $200 000
Deferred tax asset $80 000
Aggregate taxable temporary differences $150 000
Deferred tax liability $60 000
Of the deferred tax asset balance, $28 000 related to a temporary difference of $70 000
($70 000 × 40%). This deferred tax asset had previously been recognised in OCI and accumulated
in equity as a revaluation surplus.
The entity reviewed the carrying amount of the asset in accordance with para. 56 of IAS 12 and
determined that it was probable that sufficient taxable profit to allow utilisation of the deferred
tax asset would be available in the future.
Present the journal entries necessary to give effect to para. 60 of IAS 12.
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Summary
Part B of this module discussed the recognition of deferred tax assets and deferred tax liabilities.
Deferred tax liabilities are recognised for all taxable temporary differences, with certain limited
exceptions, as described in paras 15 and 39.
Deferred tax assets are recognised to the extent that it is probable that future taxable profit will
be available against which the deferred tax asset can be used, with certain limited exceptions,
as described in paras 24, 34 and 44.
A primary source of taxable profit against which the deferred tax asset can be used is the taxable
amounts that arise when taxable temporary differences reverse. Therefore, it is probable that
sufficient taxable profits will be available when there are sufficient taxable temporary differences
against which the temporary difference, or unused tax losses and credits, can be used.
When an entity does not have sufficient taxable temporary differences, utilisation of the deferred
tax asset depends on future taxable profits in excess of profits arising from the reversal of existing
future taxable temporary differences.
306 | INCOME TAXES
Part C: Special considerations for

assets measured at revalued amounts
Introduction
Recall from Part A of this module that, applying the requirements of para. 5 of IAS 12, temporary
differences are determined by comparing the carrying amount of assets and liabilities to the
tax base.
Part C of this module deals with temporary differences that arise when assets are carried at
revalued amounts and the tax base is not adjusted by an amount equivalent to the revaluation.
Relevant paragraphs
To assist in achieving the objectives of Part C, you may wish to read the following paragraphs of
IAS 12 and IAS 16 Property, Plant and Equipment. Where specified, you need to be able to apply
these paragraphs as referenced in this module:
Subject Paragraphs
IAS 12
Taxable temporary differences 18(b), 20, 26(d)
Measurement 51, 51A, 51B
Recognition of current and deferred tax 58, 61A, 62(a)
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Illustrative Examples (Part B of the Red Book) Part A (items 10, 11)
Part B (item 8)
IAS 16
Revaluation model 39–40
Assets carried at revalued amounts

International Financial Reporting Standards (IFRSs) permit a range of assets to be carried at
fair value or revalued amount. For example, after the initial recognition as an asset, an item of
property, plant and equipment may be carried at a revalued amount, being its fair value at the
date of revaluation, less any subsequent accumulated depreciation, and subsequent impairment
losses (IAS 16).
Paragraph 20 of IAS 12 explains that whether a temporary difference arises when an asset is
revalued depends on how a revaluation is treated in the relevant tax jurisdiction.
As discussed earlier in this module, the difference between the carrying amount of a revalued
asset and its tax base is a taxable or deductible temporary difference that gives rise to a deferred
tax liability or deferred tax asset.
When an asset is revalued, there are two possibilities:

1. The tax base of the asset is adjusted by the same amount as the change in the carrying
amount of the asset. Therefore, no temporary difference arises because of the revaluation.
2. The tax base of the asset is not adjusted, or is adjusted by an amount that differs from the
amount by which the asset was revalued. In this case, a taxable or deductible temporary
difference arises.
This is illustrated in Example 4.13.

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Example 4.13: The effects of a revaluation

Assume that prior to an upwards revaluation, the tax base and the carrying amount of an asset are
each $100. The asset is revalued upwards to its fair value of $180 for accounting purposes and the
tax base is adjusted by the same amount (in accordance with the tax laws of the relevant jurisdiction).
The tax rate is 30 per cent.
As the tax base is adjusted by the revaluation amount, no temporary difference arises.
Applying the formula for the tax base of an asset, the effect of the revaluation is as follows:
Future
= + deductible –
amounts
180 = 180 + 180 – 180
The temporary difference immediately before and after the revaluation is nil, as illustrated below.
Therefore, no temporary difference arises as a consequence of the revaluation.
Before revaluation After revaluation

$ $
Carrying amount 100 180
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Tax base 100 180
Temporary difference nil nil
➤➤Question 4.9
Using the same facts as Example 4.13, assume that in the tax jurisdiction concerned the amount
of the tax deduction is not altered in response to a revaluation. Therefore, the tax base is not
adjusted and remains at $100.
Calculate the taxable temporary difference immediately before and after the revaluation.
If you wish to explore this topic further you may now read paras 18(b), 20 and 26(d) of IAS 12.
Note that the circumstances in Question 4.9, where the tax base is not adjusted by the revaluation
amount, are consistent with the requirements of para. 26(d).
The module will now address the requirements for accounting for deferred tax arising from both
a revaluation increase and decrease.
308 | INCOME TAXES
Recognition of deferred tax on revaluation

As discussed in Part B of this module, the principle adopted by IAS 12 to account for the tax
effects of a transaction or other event (e.g. the recognition of current tax and deferred tax) is that
accounting for tax should be consistent with the accounting treatment of the transaction or
event itself.
In this regard, para. 58(a) of IAS 12 requires that current or deferred tax be recognised as income
or expense, except when the tax relates to items that are credited or charged either to OCI
or directly to equity. When the tax relates to items that are recognised in OCI, the current and
deferred tax is recognised in OCI. Similarly, para. 61A of IAS 12 requires that where the current
and deferred tax relates to items that are recognised directly in equity, current and deferred tax is
recognised directly in equity.
Note: None of the examples in this module relate to items recognised directly in equity. There are
some examples that relate to the revaluation of assets that are recognised in OCI and accumulated
in equity.
The required accounting treatment following a revaluation is outlined in paras 39 and 40 of IAS 16.
Following the requirements of para. 39 of IAS 16, a revaluation increase should be recognised
as an increase in OCI and accumulated in equity as a revaluation surplus, unless it reverses a
previous decrement in respect of that asset previously recognised in P&L.
Using the same facts as Question 4.9, the revaluation increase would be recognised in OCI
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(and accumulated in equity as a revaluation surplus), and the tax-effect journal entry would be:
Increment charged against revaluation surplus

$ $
Other comprehensive income—revaluation surplus 24
Deferred tax liability 24
To recognise deferred tax in other comprehensive income ($80 × 30% tax rate = $24)
If you wish to explore this topic further you may now read paras 58, 61A and 62(a) of IAS 12.
You may also read items 10 and 11 in Part A and item 8 of Part B of the Illustrative Examples to
IAS 12 (in Part B of the Red Book).
Applying the requirements of para. 61A of IAS 12, generally, the deferred tax associated with
a revaluation should be recognised in OCI if the tax relates to items that are recognised, in the
same or a different period, in OCI. This does not apply where the deferred tax relates to the
recovery of the carrying amount of the asset through use. The recovery of an asset through
use is via deductions allowed for depreciation. For example, in the financial statements, if an
asset’s accumulated depreciation is greater than the cumulative depreciation allowed for tax
purposes, the difference affects profit or loss rather than other comprehensive income (IAS 12,
Illustrative Examples, Part B—Example 2).
Paragraph 64 of IAS 12 clarifies that:

IAS 16 does not specify whether an entity should transfer each year from revaluation surplus to
retained earnings an amount equal to the difference between the depreciation or amortisation on a
revalued asset and the depreciation or amortisation based on the cost of that asset. If an entity makes
such a transfer, the amount transferred is net of any related deferred tax. Similar considerations apply
to transfers made on disposal of an item of property, plant or equipment.
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Recovery of assets through use or through sale

The amount of tax payable is affected by the manner of recovery of an asset. An entity may
realise the future economic benefits of an asset either through use or through sale.
Therefore, following the requirements of para. 51 of IAS 12, calculating the tax base is based
on how an entity expects, at the end of the reporting period, to recover or settle the carrying
amounts of its assets and liabilities.
The expectation may be to hold the asset (e.g. using an item of plant in manufacturing
operations) or sell the asset (e.g. disposing of plant that is no longer required for manufacturing
operations). Consequently, the tax base may differ in circumstances where different tax
treatments exist for each method.
This is illustrated in Example 4.14, in relation to determining the amount of the temporary
difference arising from the revaluation of a depreciable asset.
Example 4.14: T
he amount of the temporary difference
impacted by the expected manner of
recovery (depreciable asset)
A depreciable asset, with an initial cost of $100, is revalued to a new carrying amount of $150.
Immediately prior to the revaluation, the carrying amount of the asset was $80 and the amount
deductible on recovery of the asset was the tax written down amount of $70 (cost of $100 less
$30 cumulative depreciation previously allowed for tax purposes). The capital gains tax cost base
(future taxable amount if recovery of the asset is by sale) is $120 (where applicable).
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Note: The capital gains tax cost base of $120 has been provided for illustrative purposes only—it is
not necessary to know how the capital gains tax base was determined. The capital gains tax cost base
is applicable where the expected recovery of the carrying amount is through sale and capital gains
tax is applicable.
Recall that the tax base of an asset is the ‘amount that will be deductible for tax purposes against any
taxable economic benefits received by the reporting entity when it recovers the carrying amount of
the asset’ (IAS 12, para. 7).
Recovery of carrying amount by using the asset to the end of its useful life
The potential for capital gains arises only if the carrying amount of an asset is expected to be recovered
by selling the asset. If the carrying amount of the asset is recovered by use, there can be no question
of a capital gain arising.
However, when the carrying amount is recovered by using the asset to provide goods and services for
resale, the reporting entity generates $150 of income that will enter into the determination of taxable
profit (i.e. equal to the revalued carrying amount of $150). The amount deductible in determining
taxable profit is the tax written-down amount of $70; the tax base is not affected by the revaluation.
310 | INCOME TAXES
This is also the tax base of the asset, as application of the following formula shows:
Future
= + deductible –
amounts
70 = 150 + 70 – 150
Carrying Temporary
Tax base – =
amount difference
70 – 150 = 80
The reporting entity would recognise a deferred tax liability of $24 ($80 × 30%) if it expects to recover
the carrying amount by using the asset.
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In accordance with para. 61A of IAS 12, the additional deferred tax of $21 ($24† – $3‡) that arises on the
revaluation is recognised in OCI along with the revaluation increase. That is, only the amount of deferred
tax relating to the revaluation is recognised in OCI. If the asset had not been revalued, the deferred
tax liability would have been $3 (carrying amount $80 less tax base $70 multiplied by 30 per cent).
†
The asset is revalued to $150 from its carrying amount of $80. The tax base is $70 and is not affected by the
revaluation. This gives rise to a temporary difference of $80. The DTL applicable is $80 × 30% = $24.
‡
The $3 is the deferred tax liability recognised in the prior year relating to the taxable temporary difference
between the carrying amount ($80) and tax base ($70). DTL applicable was $10 × 30% = $3.
Note: Revaluation surpluses and associated tax effects ($21) are recognised in OCI. The original DTL
($3) was recognised in P&L.
Recovery of carrying amount by selling the asset

Where a reporting entity recovers the carrying amount by selling the asset, there are two possible
scenarios:
1. There is no capital gains tax applicable; therefore, if the asset is sold for the recoverable amount
of $150, the capital gain of $50 (the excess of the sale proceeds of $150 over the initial cost of
$100) is exempt from income tax.
2. Capital gains tax applies; therefore, if the asset is sold for the recoverable amount of $150,
the capital gain of $30 (the excess of the sale proceeds of $150 over the capital gains tax cost
base of $120) is subject to income tax.
Each of these scenarios is now considered.
Note: In both scenarios, the asset remains on hand; the expected recovery of the carrying amount
is through sale. If the asset had been sold, the asset no longer exists and the tax base and carrying
amount will both be $nil and any pre-existing deferred tax liability is reversed.
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1. Capital gains tax not applicable

In a regime in which there is no capital gains tax, if the asset is sold for the recoverable amount of $150,
the capital gain of $50 (the excess of the sale proceeds of $150 over the initial cost of $100) is exempt
from income tax. The carrying amount of the asset can be divided into a capital gain component of
$50 and a recovery of cost component of $100.
As this is a depreciable asset, any tax depreciation recouped (recovered) on the sale of the asset is
taxable. The tax depreciation recouped is equal to any remaining proceeds of sale, after capital gains,
in excess of the tax written-down amount of the asset.
For example:
Proceeds of sale $150 less capital gain $50 = $100
$100 – tax written-down amount $70 = $30 tax depreciation recouped
Although the capital gain is not taxable, the depreciation recouped is taxable as it has been recovered.
When an asset is first purchased, the tax base will often be equal to the initial cost. This cost is
depreciated over the life of the asset (deductible tax expense). The entity may expect to hold the asset
and derive future economic benefits through use. An entity claims deductions for tax depreciation
charged over the life of the asset. If it subsequently sells the asset for more than the tax written-down
amount (tax base), it will have recouped some, if not all, of the previously deducted tax depreciation.
In many jurisdictions, the proceeds of sale are taxable to the extent that they reflect tax depreciation
recouped. In the example presented above, the entity has claimed deductions for tax depreciation
of $30 (resulting in a tax written down value of $70). If the entity sells the asset for $150 (the revalued
carrying amount), the entity will in effect fully ‘recoup’ (recover) the $30 tax depreciation previously
claimed out of the $150 sales proceeds of the asset.
The analysis of the facts is designed to show that the manner of recovery of the carrying amount of
the asset affects the tax rate applicable to the capital gains component. The central idea is that:
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• when a capital gain is exempt from income tax, the tax rate applicable to sale proceeds in excess
of cost is, in substance, nil
• any other gains on sale are taxed at the normal rate of 30 per cent.
The tax base can be calculated as follows:
Future
deductible
of an asset = amount + – amounts
amounts
120 150 100
70
The future deductible amounts represent the written-down tax cost base. The future taxable amounts
represent the recovery of the initial cost component of the asset (i.e. the carrying amount of $150 less
the exempt capital gain of $50).
Carrying Temporary
Tax base
amount – = difference
120
150 30
Therefore, the deferred tax liability is $30 × 30% = $9. This represents the tax payable in the future
from the recoupment of the depreciation claimed.
Because there is no capital gains tax applicable, the additional $50 relating to the revaluation from
the original cost is not taxable.
This may be contrasted with the treatment on recovery of the carrying amount by using the asset.
In that case, as shown earlier, the tax rate of 30 per cent is unchanged and applies to the total gain
on revaluation of the asset.
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2. Capital gains tax applicable

In a regime where capital gains tax applies, if the asset is sold for the recoverable amount of $150,
the total capital gain is $50; however, only the capital gain of $30 (the excess of the sale proceeds of
$150 over the capital gains tax cost base of $120) is taxable.
Note: The capital gains tax cost base of $120 has been provided for illustrative purposes only—it is
not necessary to know how the capital gains tax base was determined.
In addition to the capital gain, the fact that this is also a depreciable asset means that any tax
depreciation recouped (recovered) on the sale of the asset is also taxable. The tax depreciation
recouped is equal to any remaining proceeds of sale, after capital gains, in excess of the tax written-
down amount of the asset.
For example:
Proceeds of sale $150 less capital gain $50 = $100
$100 – tax written-down amount $70 = $30 tax depreciation recouped
The entity has claimed deductions for tax depreciation of $30 (resulting in a tax written-down value
of $70). If the entity sells the asset for $150 (the revalued carrying amount), the entity will in effect
fully ‘recoup’ (recover) the $30 tax depreciation previously claimed out of the $150 sales proceeds of
the asset.
In relation to the capital gain, the taxable capital gain is $30 (the excess of the sale proceeds of $150
over the capital gains tax cost base of $120).
In this example, $30 of the capital gain and $30 of tax depreciation recouped are taxable.
Therefore, in this example, the $150 sales proceeds from the asset (equal to the revalued carrying
amount of the asset) can be divided into:
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• a taxable capital gain component of $30 (being the difference between the sales proceeds of
$150 and the capital gains tax cost base of $120)
• an exempt capital gain component of $20 (being the difference between the original cost of $100
and CGT cost base of $120)
• a recovery of the original cost of $100.
The tax base can be calculated as follows.
Future
deductible
amounts
90 150 150
90†
Carrying Temporary
Tax base
amount – = difference
90
150 60
†
The future deductible amount is comprised of the $120 capital gains tax base less the depreciation already
deducted ($30).
Therefore, there is a taxable temporary difference of $60 associated with the recovery of the asset.
As a result, the deferred tax liability is $60 × 30% = $18.
The sale proceeds include the capital gain of $30 ($150 sales proceeds less $120 capital gains tax
cost base) and recovery of the cost of the asset of $100. The entity has recovered the cost of $100,
which comprises the $70 tax written-down amount and the cumulative tax depreciation claimed to
date of $30. Therefore, in addition to the capital gain of $30, the taxable amount also includes the
$30 tax depreciation recouped.
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➤➤Question 4.10
Present the journal entry required to recognise the deferred tax liability applicable to the
revaluation recognised in Example 4.14, under the assumption that the revaluation increase was
credited to OCI and accumulated in equity as a revaluation surplus, if:
(a) the carrying amount of the asset was recovered by using the asset to the end of its useful life
(b) the carrying amount of the asset was recovered by selling the asset and capital gains tax
is applicable.
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If you wish to explore this topic further, you may now read para. 51A, Example B, in IAS 12.
This example is intended to illustrate how the expected manner of recovery of the carrying amount
of an item of property, plant and equipment may affect the tax rate applicable when an entity
recovers the carrying amount and the amount of tax that is ultimately payable or recoverable.
Additional guidance on recovery of non-depreciable assets

As discussed, the amount of tax payable is affected by the manner of recovery of an asset.
An entity may realise the future economic benefits of an asset either through use or through sale.
Paragraph 51B of IAS 12 clarifies how to interpret the term ‘recovery’ in relation to an asset that
is not depreciated and is revalued in accordance with IAS 16.
The tax consequences to consider are those that would follow from the recovery of the carrying
amount of that asset through sale, regardless of the basis of measuring the carrying amount of that
asset. The tax law may specify a tax rate applicable to the taxable amount derived from the sale
of an asset. If that rate differs from the rate applicable for using an asset, the former rate (i.e. sale)
is applied in measuring the deferred tax liability or asset related to a non-depreciable asset.
This is illustrated in Example 4.15, in relation to determining the amount of the temporary
difference arising from the revaluation of a non-depreciable asset.
314 | INCOME TAXES
Example 4.15: T
he amount of the temporary difference
impacted by the expected manner of
recovery (non-depreciable asset)
A piece of land, which is held for use, has a carrying amount and cost of $100. The land is revalued by
$50 to $150. The tax law specifies that the tax rate applicable to the taxable amount derived from sale is
20 per cent. The tax rate applicable to the taxable amount derived from using the asset is 30 per cent.
As the revalued land is a non-depreciable asset, the tax rate that is applicable when calculating any
deferred tax implications is the tax rate applicable from sale (i.e. 20 per cent).
Using the formula for the tax base of an asset:
Future
deductible
amounts
100 150 150
100
After the revaluation, the resulting temporary difference, the capital gain, is taxed at a rate of 20 per cent.
This is summarised in the following table.
Deferred tax liability after revaluation
After revaluation
$
Carrying amount of land 150
Tax base (100 )
Temporary difference/capital gain 50
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Tax rate 20%

If you wish to explore this topic further you may now read para. 51B of IAS 12.
Study guide | 315
Summary
Whether a temporary difference arises when the fair value of an asset is adjusted or an asset
is revalued depends on how a revaluation increase or decrease is treated in the relevant tax
jurisdiction.
No temporary difference is created when the tax base is adjusted by the same amount as the
carrying amount of the asset.
A taxable or deductible temporary difference arises when the tax base is not adjusted or is
adjusted by an amount that differs from the amount by which the asset was revalued.
The accounting treatment of deferred tax resulting from a revaluation follows the treatment
of the revaluation surplus. A revaluation amount may be treated either as income or expense,
or as a credit or debit to OCI and accumulated in equity as a revaluation surplus. IAS 12 requires
that current tax and deferred tax that relates to items that are recognised, in the same or a
different period:
(a) in other comprehensive income, shall be recognised in other comprehensive income …
(b) directly in equity, shall be recognised directly in equity (IAS 12, para. 61A).
The manner of recovery of an asset may affect the tax rate and/or the tax base applicable
on recovery or settlement. IAS 12 requires that deferred tax assets and liabilities should be
measured using the tax rates and tax bases that are consistent with the expected manner of
recovery or settlement of the entity’s assets and liabilities.
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316 | INCOME TAXES
Part D: Financial statement

presentation and disclosure
Introduction
As discussed in Part A of this module, the use of the balance sheet liability method of accounting
for income taxes under IAS 12 will result in the entity recognising the current and future tax
consequences of:
• transactions and other events of the current period that are recognised in an entity’s financial
statements
The objective of the presentation and disclosure requirements of IAS 12 is to disclose information
that enables users of the financial statements to understand and evaluate the impact of current
tax and deferred tax on the financial position and performance of the entity.
The presentation and disclosure requirements of IAS 12 focus primarily on the presentation of
tax balances in the statement of financial position and the disclosure of information about the
following matters:
• major components of tax expense (tax income)
• relationship between tax expense (tax income) and accounting profit
• particulars of temporary differences that give rise to the recognition of deferred tax assets
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and the deferred tax liabilities

• particulars of temporary differences, unused tax losses and unused tax credits for which no
deferred tax asset was recognised (i.e. because the probability criterion was not satisfied).
Relevant paragraphs
To assist in achieving the objectives of Part D, you may wish to read the following paragraphs of
IAS 1 and IAS 12. Where specified, you need to be able to apply these paragraphs as referenced
throughout the module:
Subject Paragraphs
IAS 1
Information to be presented in the statement of financial position 54, 56
Disclosure 82
IAS 12
Presentation 71–77
Disclosure 79–88
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Presentation of current tax and deferred tax

Current tax assets and liabilities and deferred tax assets and liabilities are presented in separate
line items in the statement of financial position as required by para. 54(n) and 54(o) of IAS 1
Presentation of Financial Statements.
This is illustrated in the financial statement extract in Table 4.10.
Table 4.10: F
inancial statement extract showing current and deferred tax
Statement of financial position at 30 June 20X1
20X1 20X0
$ $
Current assets
Cash 433 500 143 000
Trade and other receivables 375 500 216 000
Non-current assets
Property, plant and equipment 1 450 000 1 410 000
Deferred tax assets 15 000 13 500
Total assets 2 274 000 1 782 500

Current liabilities
Trade and other payables (115 000 ) (95 000 )
Current tax liabilities (191 500 ) (185 000 )
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Provisions (35 000 ) (30 000 )
Borrowings (500 000 ) (500 000 )
Deferred tax liabilities (65 000 ) (60 000 )
Provisions (15 000 ) (15 000 )

Total liabilities (921 500 ) (885 000 )
Net assets 1 352 500 897 500
Further, para. 56 of IAS 1 prohibits the classification of deferred tax assets and deferred tax
liabilities as current assets or liabilities.
Example 4.16 illustrates the presentation of tax liabilities in the statement of financial position.
318 | INCOME TAXES
Example 4.16: P
resentation of tax liabilities in the
statement of financial position
The following assumptions are relevant when preparing the disclosures for ABC Ltd:
(a) ABC Ltd received a statutory fine of $50 000 for a violation of environmental laws. This fine is
non‑deductible in the relevant tax jurisdiction.
(b) A receivable of $100 000 for accrued interest revenue, associated with loans advanced to borrowers,
was recognised in the statement of financial position of ABC Ltd as at 30 June 20X9. The revenue
is taxable when received in cash during the year ended 30 June 20Y0. This advance gave rise to
a temporary difference in 20X9, which reversed in 20Y0.
(c) Other information about taxable profit and accounting profit before tax was:
Period ended Period ended

30 June 30 June
20X9 20Y0
$ $
Accounting profit before tax 600 000 750 000
Plus (less) interest revenue (100 000 ) 100 000
Plus amounts in addition to the interest revenue
recognised in the measurement of accounting
profit before tax
Statutory fines for violation of environmental laws 50 000
Taxable profit 550 000 850 000
Current tax payable (taxable profit × 30%) 165 000 255 000
Using the above information, the amounts of the current tax liability and the deferred tax
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liability presented in the statement of financial position are as follows:
Statement of financial position extracts

30 June 20X9 30 June 20Y0
$ $
Tax liabilities
Current liabilities
Current tax payable 165 000 255 000
Deferred tax liability 30 000 0
Offsetting tax assets and liabilities

Although current tax assets and liabilities are separately recognised and measured, they are
required to be presented as a single net amount (i.e. net asset or net liability) in the statement
of financial position when certain specified criteria are satisfied (as follows).
IAS 12 requires that current tax assets (tax recoverable from the taxation authority) and current
tax liabilities (tax payable) are offset when the entity:
(a) has a legally enforceable right to set off the recognised amounts; and
(b) intends either to settle on a net basis, or to realise the asset and settle the liability
simultaneously (IAS 12, para. 71).
Similar requirements also apply to the presentation of deferred tax assets and liabilities in the
statement of financial position (as follows).
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IAS 12 requires deferred tax assets and deferred tax liabilities to be offset when:
(a) the entity has a legally enforceable right to set off current tax assets against current tax
liabilities [discussed in the previous section]; and
(b) the deferred tax assets and the deferred tax liabilities relate to income taxes levied by the
same taxation authority (IAS 12, para. 74).
In all other circumstances the amounts must be presented in the statement of financial position
on a gross basis (i.e. the statement of financial position will include two separate line items—
‘deferred tax assets’ and ‘deferred tax liabilities’).
Major components of tax expense

Tax expense (tax income) is presented as a single line item in the P&L and OCI as required
by para. 82(d) of IAS 1.
This is illustrated in the financial statement extract in Table 4.11.
Table 4.11: Financial statement extract showing tax expense line item

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20X1 20X0
$ $
Income 975 000 857 000
Expenses (325 000 ) (232 000 )
Profit before income tax 650 000 625 000
Tax expense (195 000 ) (187 500 )
In order to provide more useful information to the users of financial statements, para. 79 of
IAS 12 requires the major components of tax expense (tax income) to be disclosed separately.
This information is usually disclosed in the notes to the financial statements.
Examples of components of tax expense (tax income) are included in para. 80 of IAS 12.
An example of the note disclosure of the major components of tax expense (income) is shown
in Table 4.12.
320 | INCOME TAXES
Table 4.12: Major components of income tax expense (income)
Income tax expense for the year

US$ million 2015 2014
Current tax (expense)/benefit
Current period (206.7) (114.1)
Adjustments to current tax expense relating to prior periods 14.6 (8.7)
Tax losses, tax credits and temporary differences not recognised for book in prior 11.1 12.1
years now recouped
Tax losses and credits derecognised — (104.7)
Total current tax expense (181.0) (215.4)
Deferred tax (expense)/benefit
Origination and reversal of temporary differences (10.9) (40.7)
Change in applicable tax rates 3.9 3.6
Total deferred tax expense (7.0) (37.1)
Total income tax expense (188.0) (252.5)
Source: Amcor 2015, Annual Report 2015, p. 73, accessed November 2017,
https://www.amcor.com/corporatesite/media/annual-reports/2015-annual-report.pdf.
The extract from the Amcor Limited 2015 Annual Report discloses the major components of
income tax expense for the 2015 reporting period (and the comparative reporting period) and
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further distinguishes between ‘current tax’ and ‘deferred tax’, which together make up the
aggregate tax expense for the reporting period.
The disclosure of the major components of tax expense (tax income) is illustrated in Example 4.17.
Example 4.17: D
isclosing the major components
of tax expense (income)
This example uses the data outlined in Example 4.11.
On the basis of the data outlined in Example 4.11, and applying the requirements of para. 79 of IAS 12,
the major components of tax expense (income) for the financial year ended 30 June 20Y0 are as follows:
30 June
20Y0
Major components of tax income: $
Major components of tax expense (income)
Current tax expense (income)
Tax on taxable profit 12 000
Tax benefit from recoupment of previously unrecognised tax losses—(IAS 12, para. 80(e)) —
Current tax expense (income)—(IAS 12, para. 80(a)) 12 000
Deferred tax expense (income)
Deferred tax expense (income) relating to origination and reversal of temporary
differences—(IAS 12, para. 80(c)) —
Deferred tax expense relating to recoupment of previously unrecognised tax losses —
Deferred tax expense relating to recoupment of previously recognised tax losses 18 000
Deferred tax expense (income) on recognition of deferred tax assets —
Tax benefit arising from previously unrecognised tax losses reducing deferred
tax expense—(IAS 12, para. 80(f)) —
Deferred tax expense (income) 18 000
Tax expense (income) 30 000
Study guide | 321
Relationship between tax expense (income)

and accounting profit
As noted and illustrated previously, profit or loss for the reporting period and tax expense
(tax income) are presented as single line items in the statement of P&L and OCI as required by
para. 82(d) of IAS 1.
In order to fully understand the financial performance of the entity, it is important for users of
the financial statements to understand the relationship between tax expense (income) and profit
or loss for the reporting period (i.e. accounting profit).
Accordingly, para. 81(c) of IAS 12 requires that an explanation of the relationship between tax
expense (income) and accounting profit be provided in the notes to the financial statements.
An example of the note disclosure of the relationship between tax expense (income) and
accounting profit is shown in Table 4.13.
Table 4.13: Relationship between tax expense (income) and accounting profit
Numerical reconciliation of income tax expense to prima facie tax payable

Profit from continuing operations 895.9 888.9
Loss from discontinued operations — (104.6)
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Profit before related income tax expense 895.9 784.3
Tax at the Australian tax rate of 30% (2014: 30%) (268.8) (235.3)
Tax effect of amounts which are not deductible/(taxable) in calculating

taxable income:
Net operating items non-deductible/non-assessable for tax 24.1 20.0
Capital structures 18.9 24.9
Previously unrecognised tax losses, tax credits and temporary differences 11.1 12.1
now used to reduce income tax expense
Tax losses and credits derecognised — (104.7)
Effect of local tax rate change 3.9 3.6
(210.8) (279.4)
Over provision in prior period (7.2) 23.1
Foreign tax rate differential 30.0 3.8
Total income tax expense (188.0) (252.5)
Less income tax (expense) / benefit attributable to discontinued operations — (70.3)
Total income tax expense attributable to continuing operations (188.0) (182.2)
This extract from the Amcor 2015 Annual Report discloses the relationship between tax expense
and accounting profit by presenting a reconciliation from accounting profit (described as ‘profit
from continuing operations’) to tax expense (described as ‘total income tax expense attributable
to continuing operations’). Please note that the amounts included in the reconciliation are
presented on a ‘tax effective basis’ (i.e. at the 30% Australian tax rate).
322 | INCOME TAXES
The determination of the relevant information to be disclosed in the notes to the financial
statements to explain the relationship between tax expense (income) and accounting profit is
commonly undertaken as a two-step process, as shown in Table 4.14.
Table 4.14: Key steps for preparing the tax reconciliation
Step 1 Reconcile accounting profit to taxable profit (i.e. understand the differences between
the accounting treatment and the tax treatment).
Step 2 Determine and present the relationship between tax expense (income) and accounting
profit.
These two steps are illustrated in Examples 4.18 and 4.19.
Example 4.18: Reconcile accounting profit to taxable profit

Using the data from Example 4.16, a reconciliation of accounting profit to taxable profit is shown in
the first two columns of the accompanying table.
This reconciliation helps to identify and understand the differences between accounting treatment
and tax treatment, in order to prepare the explanation of the relationship between tax expense and
accounting profit. Column (3) shows the effect of the tax rate on each of the figures in column (2).
These are described in column (4). The initial focus will be on columns (1) and (2).
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Period ended 30 June 20X9

(2) × 30%
$ $
(1) (2) (3) (4)
Accounting profit before tax 600 000 180 000 Prima facie tax
Tax effect of expenses that are not deductible in
determining taxable profit
Add: Non-deductible statutory fines 50 000 15 000
Accounting profit adjusted for non-deductible
expenses 650 000 195 000 Tax expense
Movements in temporary differences
Deduct: Interest revenue (100 000 ) (30 000 ) Deferred tax expense
Taxable profit 550 000 165 000 Current tax expense†
†
Tax expense – deferred tax expense = current tax expense.
As indicated by the descriptions in column (1), the reconciliation begins by adding back to (deducting
from) accounting profit before tax any items of income or expense that cause taxable profit to be
greater (less) than accounting profit.
In relation to the final two columns, it is convenient to first check that the amount shown in column
(3) for tax expense does satisfy the definition of this item. This can be done by reading column (3)
from the bottom upwards and seeing that tax expense of $195 000 is the sum of current tax expense
of $165 000 and deferred tax expense of $30 000, as defined earlier. Note that the numerical value of
tax expense is the result of the tax rate and accounting profit before tax adjusted for non-temporary
differences, although tax expense is not defined in this way. These relationships will always apply,
except when tax losses are involved. This complication will be dealt with later.
Study guide | 323
Reading down column (3), the tax expense of $195 000 is $15 000 greater than the prima facie tax of
$180 000 (where ‘prima facie’ tax is calculated as the accounting profit before tax multiplied by the
30% applicable tax rate), as a consequence of the non-deductibility of the statutory fines.
Example 4.19: P
resenting the relationship between
tax expense and accounting profit
IAS 12 requires the explanation of the relationship between tax expense (income) and accounting
profit be provided in either or both of the following two forms:
(a) 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
(b) a numerical reconciliation between the average effective tax rate and the applicable
tax rate, disclosing also the basis on which the applicable tax rate is computed (IAS 12,
para. 81(c)).
Using the data from Example 4.16, this example illustrates to the two methods of presentation.
Presentation method 1:
Reconciliation between tax expense and the product of accounting profit multiplied by the
applicable tax rate:
30 June 30 June
20X9 20Y0
$ $
Accounting profit before tax 600 000 750 000
Tax at the applicable tax rate of 30% 180 000 225 000
Tax effect of expenses that are not deductible
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in determining taxable profit
Statutory fines 15 000 † —
Tax expense 195 000 225 000
The applicable tax rate is the notional income tax rate of 30 per cent.
†
Amount of the statutory fine × the applicable income tax rate = $50 000 × 30%.
Presentation method 2:
Reconciliation between the average effective tax rate and the applicable tax rate:
30 June 30 June
20X9 20Y0
% %
Applicable tax rate 30.0 30.0
Tax effect of expenses that are not deductible in
determining taxable profit
Statutory fines 2.5 † —
Average effective tax rate 32.5 ‡ 30.0
The applicable tax rate is the notional income tax rate of 30 per cent.
†
Tax effect/accounting profit before tax = $15 000/$600 000.
‡
Tax expense/accounting profit before tax = $195 000/$600 000.
324 | INCOME TAXES
Information about each type of

temporary difference
As discussed in Part A of this module, temporary differences are recognised as deferred tax
assets and deferred tax liabilities in the statement of financial position, and the movement in
deferred tax assets and liabilities is included as a component of tax expense (income) for the
reporting period.
Accordingly, it is important for the users of the financial statements to understand the nature
and amount of each type of temporary difference.
Recognised deferred tax assets and deferred tax liabilities

IAS 12 requires the following information to be disclosed in respect of each type of
temporary difference:
(a) the amount of the deferred tax assets and liabilities recognised in the statement of financial
position for each period presented; and
(b) the amount of the deferred tax income or expense recognised in profit or loss, if this is not
apparent from the changes in the amounts recognised in the statement of financial position
(IAS 12, para. 81(g)).
An example note disclosure is shown in Table 4.15.
Table 4.15: Information about each type of temporary difference

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Deferred tax assets and liabilities reconciliation
Deferred tax relates to the following:

Statement of Income
financial position statement
US$ million 2015 2014 2015 2014
Property, plant and equipment (229.8) (248.3) (0.8) 84.0
Impairment of trade receivables (1.4) 3.1 (4.2) 0.3
Intangibles (156.5) (161.7) 1.9 (20.8)
Valuation of inventories 8.0 2.2 5.0 1.4
Employee benefits 84.8 62.6 1.0 (3.8)
Provisions 30.5 47.3 (13.7) 2.3
Financial instruments at fair value and net investment (3.8) 36.9 (23.6) 23.6
hedges
Tax losses carried forward 74.6 93.8 16.3 (111.7)
Accruals and other items 41.5 7.0 11.1 (12.4)
Deferred tax (expense)/benefit (7.0) (37.1)
Net deferred tax assets/(liabilities) (152.1) (157.1)
Study guide | 325
This extract from the Amcor 2015 Annual Report discloses information about each temporary
difference that resulted in the recognition of deferred tax assets and deferred tax liabilities for
2015 (and for the comparative financial year). For example, looking at the first line of the note
disclosures in Table 4.15, temporary differences arising from property, plant and equipment
resulted in the recognition of a deferred tax liability of $229.8 million for 2015 (and $248.3 million
for 2014).
Example 4.20 illustrates the recognition of taxable temporary differences.
Example 4.20: Recognising taxable temporary differences

Using the data from Example 4.16, the amounts of deferred tax assets and deferred tax liabilities
recognised in the statement of financial position would be:
30 June 30 June
20X9 20Y0
$ $
Taxable temporary differences
Interest receivable 30 000 0
Deferred tax liability 30 000 0
Unrecognised deferred tax assets and deferred tax liabilities

Paragraph 80(e) of IAS 12 requires the disclosure of the ‘amount (and expiry date, if any)
of deductible temporary differences, unused tax losses, and unused tax credits for which no
deferred tax asset is recognised in the statement of financial position’.
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An example note disclosure is shown in Table 4.16.
Table 4.16: Unrecognised deferred tax assets and deferred tax liabilities
Unused tax losses for which no deferred tax asset has been recognised(1) 896.5 997.8
Potential tax benefits on unused tax losses at applicable rates of tax 257.6 291.9
Unrecognised tax credits 23.4 30.6
Deductible temporary differences not recognised 75.9 31.5
Total unrecognised deferred tax assets 356.9 354.0

(1)
Unused tax losses have been incurred by entities in various jurisdictions. Deferred tax assets have not
been recognised in respect of these items because it is not probable that future taxable profit will be
available in those jurisdictions against which the Group can utilise the benefits.
326 | INCOME TAXES
The following extract from the Amcor 2015 Annual Report discloses information about
unrecognised deferred tax assets and deferred tax liabilities for 2015 (and for the comparative
financial year).
Deferred tax liabilities have not been recognised in respect of temporary differences arising as a
result of the translation of the financial statements of the Group’s investments in subsidiaries and
associates. The deferred tax liability will only arise in the event of disposal of the subsidiary or
associate and no such disposal is expected in the foreseeable future.
Unremitted earnings of the Group’s international operations are considered to be reinvested
indefinitely and relate to the ongoing operations. Upon distribution of any earnings in the form of
dividends or otherwise, the Group may be subject to withholding taxes payable to various foreign
countries; however, such amounts are not considered to be significant. As the Group controls
when the deferred tax liability will be incurred and is satisfied that it will not be incurred in the
foreseeable future, the deferred tax liability has not been recognised.
For example, the note indicates that Amcor had unused tax losses of $896.5 million for 2015
for which a deferred tax asset was not recognised. In this regard, the footnote explains that
the unused tax losses were not recognised as a deferred tax asset ‘because it is not probable
that future taxable profit will be available … against which the Group can utilise the benefits’
(Amcor 2015, p. 74).
Summary
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IAS 12 requires the presentation and disclosure of several items of information about income tax.
The presentation and disclosures discussed in Part D included:
deferred tax asset was recognised (i.e. because the ‘probability criterion’ was not satisfied).
Study guide | 327
Part E: Comprehensive example

Introduction
Part E of this module looks at a comprehensive example illustrating the application of IAS 12.
A Learning Task on My Online Learning supports this comprehensive example. You can refer to the
Learning Task progressively as you work through the example here, or access it at the end for review
and additional practice.
Note that while the Learning Task provides valuable reinforcement of the module discussion, it is not
mandatory to use this resource.
Important: A thorough understanding of Parts A–D is required before beginning Part E.
The AAA Ltd case study is a comprehensive example that deals with an entity over a three-year
period: 20X0, 20X1 and 20X2. The comprehensive example covers the concepts addressed in this
module. Specific considerations covered include:
• recognition and measurement of deferred tax assets and liabilities
• recognition of deferred tax on revaluation
• goodwill
• tax losses, and recoupment of tax losses
• presentation and disclosure requirements.
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Background to AAA Ltd
The records of AAA Ltd as at 31 December 20X0–31 December 20X2 revealed the following:
(a) A deferred tax liability of $30 000 relating to a taxable temporary difference of $100 000.
The temporary difference related to a receivable that was recognised in the measurement of
accounting profit in the year ended 31 December 20X0. It was expected that the temporary
difference would reverse on receipt of cash in future reporting periods, as follows:
20X1 $45 000
20X2 $55 000
(b) A deductible temporary difference of $15 000 relating to warranty obligations, which was
expected to reverse in the future reporting periods, as follows:
20X1 $5 000
20X2 $10 000
(c) During the financial year ended 31 December 20X0, AAA Ltd received a statutory fine of
$6000 for a violation of environmental laws. This fine was non-deductible in the relevant tax
jurisdiction. The fine was paid in the financial year ended 31 December 20X1.
(d) On 1 January 20X0, AAA Ltd purchased buildings at cost of $40 000. The tax base of the
buildings before depreciation was also $40 000.
(e) Buildings were depreciated at 20 per cent per year on a straight-line basis for accounting
purposes and at 25 per cent per year on a straight-line basis for tax purposes. The building
was expected to be recovered through use.
(f) At 1.1.20X2, the building was revalued to $45 000 and the entity estimated that the remaining
useful life of the building was five years from the date of the revaluation. The revaluation
did not affect the taxable profit in 20X2 and the tax base of the building was not adjusted to
reflect the revaluation.
328 | INCOME TAXES
(g) The entity did not have a history of losses.
(h) AAA Ltd had recognised goodwill of $10 000 in its statement of financial position.
Goodwill would only be expensed if impaired.
(i) Accounting profit was as follows:

20X0 $75 000
20X1 $95 000
20X2 $110 000
(j) There were no other transactions in 20X0, 20X1 and 20X2.
(k) The tax rate was 30 per cent.
(l) The entity also had the following assets and liabilities, with their tax bases equal to the
accounting carrying amounts:
20X0 20X1 20X2

$ $ $
Inventory 2 000 2 000 2 000
Investments 33 000 33 000 33 000
Plant and equipment 10 000 10 000 10 000
Accounts payable 500 500 500
Long-term debt 20 000 20 000 20 000
Relevant paragraphs
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To assist in achieving the objectives of Part E, you may wish to read the following paragraphs
of IAS 1, IAS 12 and IAS 16. Where specified, you need to be able to apply these paragraphs as
referenced in this module.
Subject Paragraphs
IAS 1
Information to be presented in the statement of financial position 54, 56
Disclosure 82
IAS 12
Definitions 5–6
Tax base 7–11
Recognition of current tax liabilities and current tax assets 12–14
Taxable temporary differences 18(b), 20
Initial recognition of an asset or liability 22(c)
Unused tax losses and unused tax credits 34 –36
Reassessment of unrecognised deferred tax assets 37
Measurement 46–56
Recognition of current tax and deferred tax 57–60
Items recognised outside profit or loss 61A, 62(a)
Presentation 71–77
Disclosure 79–88
IAS 16
Revaluation model 39–40
Study guide | 329
Carrying amounts and tax base of buildings

The first step in determining the deferred tax effects is to calculate the deferred tax liability
associated with the buildings. Using the information in the ‘Background to AAA Ltd’ section
discussed earlier in Part E, the deferred tax liability can be calculated for the periods ending
31 December 20X0 and 31 December 20X1. This calculation is as follows.
Calculation of deferred tax liability on buildings

Taxable Deferred tax
Carrying temporary Deferred tax expense
Year amount Tax base difference liability (income)
$ $ $ $ $
1.1.X0 40 000 40 000 0 0 0
31.12.X0 32 000 30 000 2 000 600 600
31.12.X1 24 000 20 000 4 000 1 200 600
This calculation may also be demonstrated as follows.
31.12.X0 $ $
Less: Tax base Cost 40 000
Depreciation (10 000 ) (30 000 )
Taxable temporary difference 2 000
Multiplying the taxable temporary difference of $2000 × 30% tax rate, the deferred tax liability
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is $600.
31.12.X1 $ $
Depreciation (20 000 ) (20 000 )
Multiplying the taxable temporary difference of $4000 × 30% tax rate, the deferred tax liability
increases to $1200. The movement for the year is $600, which is reflected in deferred tax expense.
At 1.1.20X2, the building was revalued and the estimated useful life adjusted (see note (f) in the
‘Background to AAA Ltd’ section). Following the revaluation, the deferred tax liability calculation
is shown in Table 4.17.
330 | INCOME TAXES
Table 4.17: Calculation of deferred tax liability following revaluation
Taxable Deferred tax

Carrying temporary Deferred tax expense
Year amount Tax base difference liability (income)
$ $ $ $ $
1.1.X2 45 000 20 000 25 000 7 500 6 300†
31.12.X2 36 000 10 000 26 000 7 800 300†
†
On 1.1.20X2, the building was revalued from its carrying amount of $24 000 to $45 000—a revaluation
increase of $21 000 resulting in a movement of $6300 in deferred tax liability and deferred tax expense
(recognised in other comprehensive income (OCI)). The deferred tax expense of $6300 (recognised
in OCI) is calculated as 30% × the $21 000 revaluation increase. Recall from Part C, in accordance with
para. 61 of IAS 12, the $6300 will be debited to OCI and accumulated in equity as a revaluation surplus.
This calculation may also be demonstrated as follows.
31.12.X2 $ $
Depreciation (30 000 ) (10 000 )
Multiplying the taxable temporary difference of $26 000 by the 30 per cent tax rate, the deferred
tax liability is $7800. The deferred tax liability has increased by $300 since the beginning of the
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year. This is recognised in deferred tax expense.
Confirm that the total deferred tax liability of $7800 at 31 December 20X2 will reverse over the
remaining four-year useful life of the asset.
Study guide | 331
➤➤Question 4.11
Assume that the carrying amount and the recoverable amount through sale is $45 000 as at
31 December 20X2. Using the information in Table 4.17 as at 31 December 20X2, outline how
the calculations would differ if:
(a) The asset was expected to be recovered through sale and capital gains tax was not applicable.
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(b) The asset was expected to be recovered through sale and capital gains tax was applicable.
332 | INCOME TAXES
Other deferred tax assets and liabilities

This module has stated that, to implement the balance sheet liability method of accounting for
income tax, all taxable and deductible temporary differences are identified by:
• comparing the statement of financial position carrying amount of each asset and liability
with its tax base
• identifying all items that have a statement of financial position carrying amount of $nil but
nevertheless have a tax base.
Table 4.18 illustrates one method of identifying all taxable and deductible temporary differences.
The table lists the carrying amounts of the assets and liabilities, their tax bases and the two
temporary differences: taxable and deductible. Reference to Table 4.6 may assist with the
determination of the relationship between the carrying amount and the tax base. The bottom
section of the table shows the calculation of the deferred tax asset and liability for the year.
Table 4.18: Deferred tax assets and liabilities as at 31 December 20X0
Taxable Deductible
temporary temporary
Carrying amount Tax base difference difference
$ $ $ $
Receivable 100 000 — 100 000
Inventory 2 000 2 000
Investments 33 000 33 000
Buildings 32 000 30 000 2 000
Plant and equipment 10 000 10 000
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Goodwill† 10 000 10 000

Fines payable‡ 6 000 6 000
Warranty obligations 15 000 — 15 000
Long-term debt 20 000 20 000
Total 102 000 15 000
Deferred tax liability (× 30% tax rate) 30 600
Deferred tax asset (× 30% tax rate) 4 500
†
IAS 12 Income Tax does not permit the recognition of a deferred tax liability relating to goodwill
(IAS 12, para. 15(a)). Where the cost of goodwill is not deductible, the tax base of goodwill equals
cost. Therefore, no taxable or deductible difference arises.
‡
The fine is not deductible for tax purposes; therefore the tax base is equal to its carrying amount.
You can confirm the tax bases listed in the second column of the table by referring to paras 7
and 8 of IAS 12 or to the examples in this module. At the same time, you can confirm the taxable
temporary difference for buildings as outlined in Tables 4.7 and 4.8. Also note that there are no
opening deferred tax asset or deferred tax liability balances. If such balances did exist at the
beginning of the year, these would need to be considered when constructing the statement of
financial position.
Study guide | 333
➤➤Question 4.12
Part A
Construct a table identifying all taxable and deductible temporary differences for AAA Ltd for
the year ending 31 December 20X1, and a table identifying all taxable and deductible temporary
differences for AAA Ltd for the year ending 31 December 20X2.
The tables should include the carrying amounts of the assets and liabilities, their corresponding
tax bases and the two types of temporary differences: taxable and deductible. The bottom section
of the table should illustrate the calculation of the deferred tax asset and liability for the year.
Part B
How would the answer for the year ended 31 December 20X2 differ if the tax rate changed from
30 per cent to 25 per cent in 20X2?
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Taxable profit and current tax expense
Having calculated the deferred tax for each of the three years, it is now possible to construct the
current tax expense calculation, as shown in Table 4.19.
Table 4.19: Calculation of current tax expense
Period ended 31 December 20X0

(2) × 30%
$ $
(1) (2) (3) (4)
Adjustment for non-temporary differences and
excluded temporary differences
Statutory fines 6 000 1 800
Accounting profit adjusted for non-temporary
and excluded temporary differences 81 000 24 300 Tax expense
Add: Warranty obligations 15 000
Accounting depreciation 8 000
Deduct: Receivables (100 000 )
Tax depreciation (10 000 ) (26 100 ) Deferred tax expense
Taxable profit (loss) (6 000 ) (1 800 ) Current tax income
334 | INCOME TAXES
For the period ended 31 December 20X0, a taxable loss results. A deferred tax asset may be recognised to
the extent that it is probable that future taxable profit will be available against which the deferred tax asset
can be used. A primary source of taxable profit is the reversal of taxable temporary differences.
In this example, the expected reversal of the taxable temporary difference in each of years 20X1 and
20X2 is greater than the expected reversals of the deductible temporary difference in each of these years.
This means that the expected taxable profits in each of 20X1 and 20X2, arising from the reversal of the
taxable temporary differences, are sufficient to absorb the amounts of the deductible temporary differences
that reverse in each period. As a consequence, AAA Ltd should recognise a deferred tax asset of $1800
($6000 × 30%) as at 31 December 20X0.

(2) × 30%
$ $
(1) (2) (3) (4)
Adjustment for non-temporary differences and
excluded temporary differences — —
Add: Receivable 45 000
Deduct: Warranty obligations (5 000 )
Tax depreciation (10 000 )
Recoupment of previously
recognised tax losses (6 000 ) 9 600 Deferred tax income
Taxable profit (loss) 127 000 38 100 Current tax expense
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(2) × 30%
$ $
(1) (2) (3) (4)
Adjustment for non-temporary differences
and excluded temporary differences — —
Add: Receivable 55 000
Deduct: Warranty obligations (10 000 )
Tax depreciation (10 000 ) 13 200 Deferred tax income
Taxable profit (loss) 154 000 46 200 Current tax expense
Note that this table does not include the tax effects of items recognised in OCI. In this example,
the revaluation of the building on 1 January 20X2 increased deferred tax liability by $6300 and the
corresponding deferred tax expense was recognised in OCI. As the revaluation is not recognised in
P&L, the tax effect of the revaluation is not included in the amount for deferred tax income.
At 31 December 20X2, the net movement in deferred tax liability is $6900 ($14 700 – $7800). However,
it has two parts: deferred tax expense recognised in OCI $6300 (Dr) and deferred tax income recognised
in P&L of $13 200 (Cr).

Study guide | 335
➤➤Question 4.13
How would the answer for the year ended 31 December 20X0 in Table 4.19 differ if the entity
had a history of losses?
Illustrative disclosures
The disclosures required by IAS 12, paras 79 and 80, are illustrated as follows:
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31 Dec 31 Dec 31 Dec
20X0 20X1 20X2
$ $ $
Current tax expense (income) (1 800 ) 38 100 46 200
Deferred tax expense (income) relating to the
origination and reversal of temporary differences 26 100 (9 600 ) (13 200 )
Tax expense 24 300 28 500 33 000

The disclosures required by para. 54(n) and 54(o) of IAS 1 are illustrated as follows:
Statement of financial position extracts

20X0 20X1 20X2
$ $ $
Tax liabilities
Current tax payable 38 100 46 200
Deferred tax liability 24 300 † 14 700 7 800 ‡
Tax assets
Deferred tax asset — — —

†
The $24 300 includes the $1800 DTA resulting from the tax losses and the $26 100 net DTL.

‡
The $7800 includes the $1200 DTL existing at 31 December 20X1 and the $6300, additional DTL
arising on revaluation of the asset (30% × $21 000 revaluation increase), and the additional $300
DTL arising due to depreciation differences between accounting and tax. Recall from Part C,
in accordance with para. 61 of IAS 12, the $6300 additional DTL arising from the revaluation of
the asset will be debited to OCI accumulated in equity as a revaluation surplus.
336 | INCOME TAXES
Relationship between tax expense and accounting profit

The disclosures required by IAS 12, para. 81(c)(i), are illustrated as follows:
Relationship between tax expense and accounting profit

20X0 20X1 20X2
$ $ $
Accounting profit before tax 75 000 95 000 110 000
Tax at the applicable tax rate of 30% 22 500 28 500 33 000
Tax effect of expenses that are not deductible
in determining taxable profit
Statutory fines 1 800 0 0
Tax expense 24 300 28 500 33 000
IAS 12, para. 81(c)(ii), allows that this disclosure may alternatively be made on a percentage basis.
Information about each type of temporary difference

Since the amount of deferred tax income and expense recognised in P&L for the current year
is apparent from changes in the amounts recognised in the statement of financial position,
the following satisfies the disclosure requirements of IAS 12, para. 81(g).
The amounts of deferred tax assets and deferred tax liabilities recognised in the statement
of financial position would be:
20X0 20X1 20X2
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$ $ $
Taxable temporary differences
Buildings 600 1 200 7 800
Receivable 30 000 16 500 0
Deferred tax liability 30 600 17 700 7 800 ‡
Deductible temporary differences

Warranty obligations 4 500 3 000 0
Deferred tax asset 4 500 † 3 000 ‡ 0
†
Refer to Table 4.18 for calculation.
‡
Refer to Question 4.12 suggested answer for calculation.
Summary
Part E of this module has worked through a comprehensive example that illustrates the specific
applications of IAS 12, including:
• recognition and measurement of deferred tax assets and liabilities
• recognition of deferred tax on revaluation
• goodwill
• tax losses and recoupment of tax losses
• presentation and disclosure requirements.
If you haven’t already done so, you can now access the Learning Task: Income taxes on My Online
Learning that provides additional practice on deferred tax assets and liabilities, tax expense and
Note that while the Learning Task provides valuable reinforcement of the module discussion, it is not
mandatory to use this resource.
Study guide | 337
Review
This module focused on accounting for income tax under IAS 12.
As a significant business expense for many entities, it is important for users and preparers
of financial statements to have a clear understanding of the manner in which income tax
expense, and the related income tax assets and liabilities, are calculated and recognised in
the financial statements.
The method prescribed by IAS 12 to account for income taxes is commonly referred to as the
‘balance sheet liability method’. This is because a major aspect of the calculation of income tax
expense, and the related income tax assets and liabilities, under IAS 12 requires consideration
of the difference between the carrying amounts of assets and liabilities (as recognised in the
financial statements) and the underlying ‘tax base’ of those assets and liabilities (as determined
according to the tax rates and tax laws enacted in the relevant jurisdiction).
As discussed in Part A of this module, the core principle of IAS 12 is that the financial statements
should recognise the current and future tax consequences of:
From a conceptual perspective, the recognition of the future tax consequences of the expected
recovery (settlement) of the carrying amounts of assets (liabilities) recognised in the statement of
financial position provides a more complete picture of the financial position of the entity.
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These current and future tax consequences are reflected in the financial statements, as shown in
Table 4.1 earlier in the module; refer back to Table 4.1 to refresh your memory on income tax line
items in financial statements.
As discussed in Part B of this module, IAS 12 requires an entity to recognise deferred tax assets
and deferred tax liabilities, with certain limited exceptions. These recognition rules (and limited
recognition exceptions) implement the recognition criteria of the Conceptual Framework in
the specific context of the nature of deferred tax assets and deferred tax liabilities.
In accordance with these recognition rules (and limited recognition exceptions):

• a deferred tax liability must be recognised for all taxable temporary differences, except for
certain limited exclusions
• a deferred tax asset must be recognised for all deductible temporary differences to the
extent that it is probable that taxable profit will be available against which the deductible
temporary difference can be utilised, except for certain limited exclusions.
As discussed in Part D of this module, the presentation and disclosure requirements of IAS 12
focus primarily on the presentation of tax balances in the statement of financial position and the
disclosure of information about the following matters:
deferred tax asset was recognised (i.e. because the probability criterion was not satisfied).
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Suggested answers
Suggested answers
Question 4.1
(a)
Future
= + deductible –
amounts
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250 = 250 + 250 – 250
The carrying amount of the inventory in the financial statements is $250, as provided in the
facts to the question.
The future deductible amounts are equal to the tax cost of the inventory, $250. When the
inventory is sold, the tax cost of the inventory (as provided in the facts to the question) will be
included as a deduction against the taxable proceeds on sale of the inventory.
The future taxable amounts reflect the future taxable economic benefits of the asset. That is,
when the entity sells the inventory, it generates revenue and so recovers the carrying amount
of the item. In this example the income on sale of inventory is taxable, so future taxable
amounts associated with the asset are equal to the carrying amount of $250. Therefore,
the tax base is $250.
340 | INCOME TAXES
(b)
250 = 200 + 50 – nil
For accounting purposes, the reduced amount of $200 is used, as this reflects the expected
amount that will be recovered in the future. However, for tax purposes, the total of $250 is
recognised until the doubtful debt is written off. This highlights the difference between the
accounting position and the tax position on this item. The formula can be applied to this
as follows:
–– The carrying amount of the accounts receivable in the accounting records is calculated
as gross carrying amount ($250) less allowance for doubtful debts ($50), which is equal
to $200.
–– The future deductible amount is the allowance for doubtful debts ($50). When the
doubtful debt is written off as not recoverable, the amount currently included in the
allowance for doubtful debts will be included as a deduction for tax purposes.
–– There are no future taxable amounts as the related revenue associated with the
accounts receivable has already been included in taxable profit (tax loss). Therefore,
the tax base is $250.
Question 4.2
The first step is to determine whether the liability is either:
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• a liability that is not revenue received in advance, or

• a liability that is revenue received in advance.
(a)
Tax base of a
Future
= – deductible +
amounts
in advance
nil = 100 – 100 + nil
The carrying amount of the employee benefits is $100.
The employee benefits will be deductible when paid; therefore, the future deductible
amount is $100.
There are no future taxable amounts because there is no revenue associated with the
payment of employee benefits to be included in taxable profit (tax loss). Therefore, the tax
base is $nil.
(b)
250 = 250 – nil + nil
The carrying amount of the loan is $250.
The loan repayment has no tax consequences; therefore, there are no future deductible or
taxable amounts. Therefore, the tax base is $250.
(c)
Tax base Amount of
of revenue Carrying revenue not
= –
received amount taxable
in advance in the future
nil = 400 – 400
The carrying amount of the revenue received in advance is $400.
The revenue received in advance has already been taxed; therefore, the amount not taxable
in the future is $400. Therefore, the tax base is $nil.
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Question 4.3
(a) According to para. 10 of IAS 12, an entity shall, with certain limited exceptions, recognise a
deferred tax liability (asset) whenever recovery or settlement of the carrying amount of the
asset or liability will make future tax payments larger (smaller) than they would be if such
recovery or settlement were to have no tax consequences.
In this scenario, the tax base is $100 and the carrying amount is $80. A deferred tax asset
arises from a deductible temporary difference because the carrying amount is less than the
tax base. It is expected that only $80 of the trade receivable will be recovered (the remaining
$20 is doubtful). If only $80 is recovered, a tax deduction of $20 for the bad debt will arise.
The tax deduction will cause future tax payments to be smaller than they would have been
in the absence of the tax consequence. Therefore, in accordance with para. 10 of IAS 12,
a deferred tax asset arises.
(b) The amount of the deductible temporary difference implied by the answer to Part (a) of this
question is $20.
342 | INCOME TAXES
(c) The relevant formulas are:
Future
= + deductible –
amounts
100 = 80 + 20 – 0
Temporary Carrying
= – Tax base
difference amount
20 = 80 – 100
There are no future taxable amounts, as the related revenue (sales) has already been included
in taxable profit (tax loss).
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(d) This modified example falls into cell 2 of Table 4.6 since the relationship between the carrying
amount of the asset and the tax base is:
Carrying amount of asset < tax base of asset
This confirms that the recovery of the receivable gives rise to a deferred tax asset.
Before leaving this modification to Example 3 of IAS 12, para. 7, it is helpful to note that deferred
tax assets are defined as amounts of income taxes recoverable in future periods. Recall that
the $100 of revenue has already been included in taxable income and tax on this amount has
previously been paid. The deferred tax asset of $6 is that portion of the tax previously paid that
will be recovered when the debt is written off and the $20 is deducted from taxable profit.

Question 4.4
Part A
(a) The explanations are as follows.
Development costs
When the carrying amount of the development costs is recovered by using the asset,
the entity will generate assessable income. Since the whole of the development expenditure
has already been deducted for tax purposes, there will be no amount deductible against
the assessable amount. Consequently, tax will become payable on the revenue earned.
Therefore, the entity should recognise a deferred tax liability for the additional tax payable
of $1000 × 30% = $300.
Prepaid expenses
The reasoning for this item is the same as that for development costs. To recover the carrying
amount of the asset, the entity generates taxable revenue of an amount equal to the carrying
amount of the prepaid expenses. However, there will be no amount deductible against the
revenue earned, the amount already having been deducted for tax purposes. Therefore,
tax will be payable on the whole of the economic benefits recovered. The entity should
recognise a deferred tax liability for the future tax payments of $1000 × 30% = $300.
(b) The following formulas are applicable for both items.
Future
= + deductible –
amounts
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0 = 1000 + 0 – 1000
Temporary Carrying
= – Tax base
difference amount
1000 = 1000 – 0

344 | INCOME TAXES
Part B
(a) The $20 difference between the carrying amount of the liability and the tax base is a deductible
temporary difference. When the liability is settled in a later period, an additional $20 will be
required to purchase the foreign currency needed to settle the liability. This extra amount will
be deductible for tax purposes. When the amount is deducted, taxable profit will be reduced
by $20 and tax payments will be reduced by $6 ($20 × 30%). Therefore, the entity recognises
a deferred tax asset of $6.
(b) The amount of the deductible temporary difference implied by the answer to Part (a) of
this question is $20, which is the amount by which the carrying amount of the liability has
been adjusted.
(c) As the temporary difference is $20, the tax base must be $100; $20 less than the $120 carrying
amount of the liability.
(d)
Tax base of a Future
= – deductible +
amounts
in advance
100 = 120 – 20 + 0
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Temporary Carrying
= – Tax base
difference amount
20 = 120 – 100

Question 4.5
(a) The analysis of the data for Example 4.8 indicates that the entity should recognise the
following deferred tax balances that originated during 20X9:
Deferred tax asset $13 500 ($45 000 × 30%)

Deferred tax liability $30 000 ($100 000 × 30%)
There were no other transactions during 20X9, so these are the net movements in
the deferred tax balances for the period. Therefore, the related deferred tax expense
and deferred tax income are:
Deferred tax income† $13 500

Deferred tax expense $30 000

†
It is acceptable to recognise this as a reduction in the deferred tax expense account instead
of an increase in deferred tax income.
Also note that taxable profit for the year ended 31 December 20X9 was $nil. Therefore,
current tax is $nil by definition (IAS 12, para. 5). Tax expense (income) is the aggregate
of current tax expense (income) and deferred tax expense (income) (IAS 12, para. 6).
Hence, tax expense for the period is:
$ $
Current tax expense 0
Less: Deferred tax income (13 500 ) 16 500
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Tax expense 16 500
Therefore, the income tax journal entry is:
31 December $ $
20X9
Deferred tax expense (net) 16 500
Deferred tax liability 30 000
(b) Since the tax loss can be carried back for three years, the expected loss in 20Y0 would
be available for offset against the taxable income of 20X9 and the two preceding years.
Taxable income for 20X9 was $nil. Therefore, recognition of the balance of the deferred tax
asset, $4500, is contingent on there being sufficient taxable profit in 20X8 and 20X7.

346 | INCOME TAXES
Question 4.6
Future
= + deductible –
amounts
(a) Using the above formula, the tax bases of the assets of Lowsales Ltd as at 30 June 20X1 are:
Future Future
Carrying deductible taxable
amount amounts amounts Tax base
Asset $ $ $ $
Cash assets 97 000 0 0 97 000
Accounts receivable (net)† 234 000 11 000 0 245 000
Prepaid rent‡ 4 000 0 4 000 0
Inventory 228 000 228 000 228 000 228 000
Equipment (net)§ 48 000 40 000 48 000 40 000
†
Revenue, which led to accounts receivable, is included in taxable profit in the same year, but the
allowance for doubtful debts will be deductible in the future when the debt becomes bad.
‡
When the prepaid rent is recovered in the future, there will be a taxable amount of $4000.
However, there will be no future deductible amounts, as the prepaid rent has already been
claimed as a deduction (i.e. when it was paid).
§
The future deductible amounts for equipment will be the cost of the equipment ($80 000)
less tax accumulated depreciation as at 30 June 20X1 ($40 000).
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Tax base of a
Future
= – deductible +
amounts
in advance

Future Future
Carrying deductible taxable
Liability—not revenue amount amounts amounts Tax base
received in advance $ $ $ $
Accounts payable 67 000 0 0 67 000
Bank loan 100 000 0 0 100 000
Foreign currency loan payable
†
32 000 0 1 000 33 000
Provision for employee benefits liability‡ 65 000 65 000 0 0
†
When the foreign currency liability is settled in a later period, $1000 less will be required to
purchase the foreign currency needed to settle the liability. This $1000 difference will be taxable.
‡
The settlement of the employee benefits liability will result in future tax deductions.
Tax base for a liability Future non-taxable

Carrying
that is revenue received = – amount of revenue
amount
in advanced

For the revenue received in advance by Lowsales Ltd, the tax base is equal to the carrying
amount of the liability ($18 000) less the amount already included in taxable profit and
therefore non-taxable in the future ($18 000), which equals $0.
(b) The format of the following deferred tax worksheet is an adaptation of the deferred tax
worksheet in the Illustrative Examples, ‘Illustrative computations and presentation’, of IAS 12.
Deferred tax worksheet for Lowsales Ltd as at 30 June 20X1:
Taxable Deductible
Carrying temporary temporary
amount Tax base differences differences
$ $ $ $
Cash assets 97 000 97 000
Accounts receivable (net) 234 000 245 000 11 000
Prepaid rent 4 000 0 4 000
Inventory 228 000 228 000
Equipment (net) 48 000 40 000 8 000
Total assets 611 000 610 000
Accounts payable 67 000 67 000

Revenue received in advance 18 000 0 18 000
Bank loan 100 000 100 000
Foreign currency loan payable 32 000 33 000 1 000
Employee benefits liability 65 000 0 65 000
Total liabilities 282 000 200 000
13 000 94 000
Deferred tax liability 3 900 †
Deferred tax asset 28 200 ‡
Less: Opening deferred tax liability/asset§ (2 400 ) (16 200 )
Movement in deferred tax liability/asset 1 500 Cr 12 000 Dr
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Deferred tax expense 1 500 Dr 12 000 Cr
†
Total taxable temporary difference $13 000 × 30%.
‡
Total deductible temporary difference $94 000 × 30%.
§
As the deferred tax asset and liability are likely to be offset (refer to Part D of the module for
discussion of offsetting), the worksheet could have also been prepared on a net deferred tax asset
basis. In that case, there would be an opening net deferred tax asset of $13 800 ($16 200 – $2400)
and a closing deferred tax asset of $24 300 ($28 200 – $3900), a net increase of $10 500.
(c) Now that current tax expense and deferred tax expense have been determined for
Lowsales Ltd, the following income taxes journal entry would be prepared:
30 June 20X1 $ $
Deferred tax liability 1 500 †
Deferred tax asset 12 000 ‡


Current tax payable 99 300 §
Total tax expense is $99 300 – $12 000 + $1500 = $88 800.
†
Movement in the deferred tax liability for the year (calculated in the deferred tax worksheet in
Part (b)).
‡
Movement in the deferred tax asset for the year (calculated in the deferred tax worksheet
in Part (b)).
§
Calculated as taxable profit of $331 000 × 30% = $99 300. The taxable profit was provided in
the facts of the question.

348 | INCOME TAXES
Question 4.7
Bayside Ltd incurred a tax loss of $7000 during the period ended 30 June 20X9. During the loss
year, the excess of tax depreciation over accounting depreciation was $1000, causing the related
temporary difference to increase by the same amount. This movement in the taxable temporary
difference caused the entity to recognise an increment in the deferred tax liability of $300,
increasing the item from the opening balance of $600 to $900.
The tax loss for the period was $7000, giving rise to a deferred tax asset of $2100. However,
the probable future taxable profit arising from the reversal of taxable temporary differences
(via depreciation) at 30 June 20X9 was only $3000 (opening $2000 + additional tax depreciation
$1000). As at 30 June 20X9, the entity was unable to establish that it was probable there would
be future taxable profits in excess of the reversal of this taxable temporary difference of $3000.
Therefore, the entity recognises only $900 of the total tax deferred tax asset, using the benefit
of only $3000 ($900 / 30%) of the total tax losses of $7000.
The journal entries are, therefore, now described.
The first entry recognises the $900 deferred tax asset that results from the tax losses that the
entity believes will be recovered from the reversal of taxable temporary differences.
30 June
20X9 $ $
Deferred tax asset 900
Current tax income 900
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The second entry relates to the increase in the deferred tax liability as a result of the additional
tax depreciation during the 20X9 financial year.
Deferred tax expense 300

As at 30 June 20X9, tax losses for which no deferred tax income had been recognised were $4000.
Year ended 30 June 20Y0

During the year ended 30 June 20Y0, the excess of tax depreciation over accounting depreciation
was $800, causing the related taxable temporary difference to increase by the same amount.
This movement in the taxable temporary difference causes the entity to recognise an additional
$240 to the deferred tax liability.
Recognising an increase in the deferred tax liability implies that it is probable that there will
be a further $800 ($240 / 30%) of taxable profit against which an additional $800 of unrecognised
tax losses can be offset. As a consequence, the entity recognises an extra deferred tax asset
of $240.
For the year ended 30 June 20Y0, the taxable profit before utilising tax losses was $2000.
Therefore, tax losses of $2000 may be recouped (recovered) for this period. When tax losses
are recouped, the benefit from the recoupment is first allocated to tax losses for which no
deferred tax asset was previously recognised, and then to tax losses for which a deferred tax
asset was previously recognised.
Recall that, in the previous period, deferred tax assets were recognised with respect to only
$3000 of the tax losses arising during the year ended 30 June 20X9. Therefore, there were
unrecognised benefits associated with $4000 of tax losses (unrecognised tax losses) as at
30 June 20X9. A consequence of recognising an additional $240 to the deferred tax asset is
that unrecognised tax losses are reduced by a further $800 ($240 / 30%), leaving a balance
of unrecognised tax losses of $3200.
Therefore, the whole of the benefit of the $2000 of tax losses recouped during the year
ended 30 June 20Y0 is attributed to tax losses for which no benefit was previously recognised.
This reduces unrecognised tax losses to $1200.
The applicable journal entry is:
30 June
20Y0 $ $

Recognition of additional deferred tax liability and deferred tax asset ($800 × 30%)

Recoupment of tax losses not previously recognised ($2000 × 30%)
Year ended 30 June 20Y1
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During the year ended 30 June 20Y1, the excess of tax depreciation over accounting depreciation
was $700, causing the related taxable temporary difference to increase by the same amount.
This movement in the taxable temporary difference causes the entity to recognise an additional
$210 to the deferred tax liability.
During the previous reporting period, tax losses of $2000 were recouped, leaving a $5000
balance of tax losses yet to be recouped. For the year ended 30 June 20Y1, taxable profit before
using tax losses was $7000. This is sufficient to absorb the balance of the unrecouped tax losses.
The benefit of the losses recouped is allocated in the order discussed earlier.
As at 30 June 20Y0, tax losses for which no deferred tax income had yet been recognised
(unrecognised tax losses) were $1200 and those for which a benefit had been recognised were
$3800. Therefore, the benefit of the first $1200 of tax losses recouped is allocated to the first
category of tax losses. The remainder is allocated to the $3800 of tax losses for which a deferred
tax asset had been recognised.
The journal entry is:
30 June
20Y1 $ $
Recoupment of tax losses not previously recognised ($1200 × 30%)

Recoupment of tax losses previously recognised: reversal of DTA that had been
created for $3800 of tax losses (20X9 $900, 20Y0 $240)
350 | INCOME TAXES
$ $
Deferred tax liability resulting from additional tax depreciation of $700
Current tax expense 600

Current tax payable 600
Recognition of tax liability on taxable profit of $2000
Unrecognised tax losses†

Year ended Year ended Year ended
30 June 30 June 30 June
20X9 20Y0 20Y1
$ $ $
(1) (2) (3)
1. Unrecognised tax losses at beginning — 4 000 1 200
2. Add tax losses incurred this period 7 000 — —
7 000 4 000 1 200
3. Tax losses for which deferred tax asset
recognised this period (3 000 ) (800 ) —
4. Unrecognised tax losses recouped
this period — (2 000 ) (1 200 )
5. Unrecognised tax loss at end 4 000 1 200 —
6. Tax losses for which deferred tax asset
recognised at end 3 000 3 800 —
†
‘Unrecognised tax losses’ refers to tax losses for which no deferred tax asset has been previously
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recognised.
Question 4.8
The adjusted balances of the deferred tax accounts under the new tax rate are:
Deferred tax asset

$
Previously credited to OCI—equity $70 000 × 0.45 = 31 500
Previously recognised as income $130 000 × 0.45 = 58 500
90 000
Deferred tax liability

Previously recognised as expense $150 000 × 0.45 = 67 500
The net adjustment to deferred tax expense is a reduction of $2500. Of this amount $3500
is recognised in OCI and $1000 is charged to P&L.
The amounts are calculated as follows:

Increase
Carrying Carrying (decrease) in
amount amount deferred tax
at 45% at 40% expense
$ $ $
Deferred tax asset
Previously credited to OCI—equity 31 500 28 000 (3 500 )†
Previously recognised as income 58 500 52 000 (6 500 )‡
90 000 80 000 (10 000 )
Previously recognised as expense 67 500 60 000 7 500 §
Net adjustment (2 500 )
Notes: $
†
An alternative method of calculation is: $70 000 × (0.45 – 0.40) = 3 500
‡
§
The journal entry is:

$ $
OCI—revaluation surplus 3 500

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The previous journal entries can be combined as follows:

$ $
Deferred tax expense† 1 000
OCI—revaluation surplus 3 500
$
†
Increase in deferred tax liability previously recognised as expense 7 500
Less: Increase in deferred tax asset previously recognised as revenue 6 500
Net deferred tax expense 1 000

352 | INCOME TAXES
Question 4.9
As illustrated below, the temporary difference after the revaluation is a taxable amount of $80.
Before revaluation After revaluation

$ $
Tax base 100 100
Temporary difference Nil 80
In future periods when the entity recovers the $180 carrying amount of the asset by use or by
sale, the amount deductible in determining taxable profit is $100. Therefore, the net taxable
amount is $80, giving rise to a deferred tax liability of $24 ($80 × 30%).
Question 4.10
(a) Carrying amount recovered by using the asset
$ $
To recognise additional deferred tax as an adjustment
to OCI accumulated in the revaluation surplus (i.e. $24 – $3)
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(b) Carrying amount recovered by selling the asset

To recognise additional deferred tax as an adjustment
to OCI accumulated in the revaluation surplus (i.e. $18 – $3)
Note: full details of the calculations are provided in Example 4.14.

Question 4.11
(a) Capital gains tax not applicable
In a regime in which there is no capital gains tax, if the asset is sold for the recoverable
amount of $45 000, the capital gain of $5000 (the excess of the sale proceeds $45 000
over initial cost of $40 000) is exempt from income tax. However, this is a depreciable asset
and any tax depreciation recouped from the sale of the asset is taxable. Tax depreciation
recouped is equal to any remaining proceeds of sale, after capital gains, in excess of the tax
written-down amount of the asset.
Therefore, as shown below, there is a taxable temporary difference of $30 000 associated
with the recovery of the asset:
Recovery by sale $ $
Sales proceeds 45 000
Less: Capital gain (5 000 )
Cost (Balance of sale proceeds) 40 000
Less: Tax written-down cost
Cost 40 000
Depreciation (30 000 ) (10 000 )
Because there is no capital gains tax applicable, the depreciation recouped is equal to the
taxable temporary difference. The deferred tax liability is $30 000 × 30% = $9000.
(b) Capital gains tax applicable
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In a regime in which capital gains tax applies, if the asset is sold for the recoverable amount
of $45 000, the capital gain of $5000 (the excess of the sale proceeds $45 000 over initial
cost of $40 000) is taxable. As noted above, in addition to the capital gain, because this is a
depreciable asset, any tax depreciation recouped from the sale of the asset is also taxable.
Tax depreciation recouped is equal to any remaining proceeds of sale, after capital gains,
in excess of the tax written down amount of the asset.
As shown below, there is a taxable temporary difference of $35 000 associated with the
recovery of the asset. The taxable temporary difference can be disaggregated between
the $5000 capital gain and $30 000 recoupment of depreciation:
Recovery by sale $ $
Sales proceeds (recovery of cost of
$40 000 plus $5000 capital gain) 45 000
Less: Tax written-down cost
Cost 40 000
Depreciation (30 000 ) (10 000 )
The deferred tax liability is $35 000 × 30% = $10 500.

354 | INCOME TAXES
Question 4.12
Part A
Taxable Deductible
amount Tax base difference difference
20X1 $ $ $ $
Receivable 55 000 — 55 000
Buildings 24 000 20 000 4 000
Warranty obligations 10 000 — 10 000
Goodwill 10 000 10 000
Total 59 000 10 000
Deferred tax asset (× 30% tax rate) 3 000
Taxable Deductible
amount Tax base difference difference
20X2 $ $ $ $
Receivable — —
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Buildings (refer to Table 4.17) 36 000 10 000 26 000
Warranty obligations — —
Goodwill 10 000 10 000
Total 26 000 0
Deferred tax asset (× 30% tax rate) 0
Part B
Current tax liabilities (assets) are to be recognised at each reporting date at the amounts that are
expected to be paid to (recovered from) the taxation authorities. The tax rates and tax laws to be
applied are those that have been enacted or substantively enacted by the end of the reporting
period (IAS 12, para. 46).
Deferred tax assets and liabilities are to be measured at the tax rates expected to apply on
realisation or settlement of the deferred tax assets and deferred tax liabilities, respectively.
The expected tax rates and the tax laws to be applied are those that have been enacted or
substantively enacted by the end of the reporting period (IAS 12, para. 47).
Therefore, AAA Ltd should measure the deferred tax assets and deferred tax liabilities using
the new tax rate of 25 per cent. The deferred tax liability would be $26 000 × 0.25 = $6500.

Question 4.13
If an entity has a history of losses, special consideration should be given to establishing whether
or not sufficient taxable profit will be available against which the deductible temporary difference
can be utilised. In this case, IAS 12 requires that the guidance provided in paras 35 and 36 be
considered (IAS 12, para. 31). This guidance requires that, when utilisation of a deferred tax asset
is dependent on future taxable profit in excess of the taxable profit arising from the reversal of
existing taxable temporary differences, the probability recognition criterion will be satisfied only
if there is convincing other evidence that such taxable profits will be available.
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References | 357
Reference
References
Amcor 2015, Annual Report 2015, accessed November 2017, https://www.amcor.com/

corporatesite/media/annual-reports/2015-annual-report.pdf.
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MODULE 4
FINANCIAL REPORTING
Module 5
BUSINESS COMBINATIONS AND
GROUP ACCOUNTING
360 | BUSINESS COMBINATIONS AND GROUP ACCOUNTING
Contents
Preview 363
Introduction
Objectives
Teaching materials
Part A: Business combinations

369
Introduction 369
Assumed knowledge
Identifying a business combination 371
The acquisition method 373
(a) Identifying the acquirer
(b) Determining the acquisition date
(c) R
ecognising and measuring the identifiable assets acquired, the liabilities
assumed and any non-controlling interest in the acquiree
(d) Recognising and measuring goodwill or a gain from a bargain purchase
Applying the acquisition method to different forms of business
combinations 385
Deferred tax arising from a business combination 388
Deferred tax related to assets and liabilities acquired in a business combination
Disclosures: Business combinations 393
Summary 393
Part B: Consolidated financial statements

395
Introduction 395
Assumed knowledge
Introduction to consolidated financial statements 397
The group 398
Defining the group
Concept of control
Preparation of consolidated financial statements 404
Parent with an equity interest in a subsidiary
Revaluation of assets
Depreciation adjustments related to revaluation of depreciable assets
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Transactions within the group

Non-controlling interest
Disclosures: Consolidated financial statements 437
Consolidated statement of financial position
Consolidated statement of profit or loss and other comprehensive income
Consolidated statement of changes in equity
Consolidated statement of cash flows
Notes including accounting policies and explanatory notes
Summary 440
Part C: Investments in associates

441
Introduction 441
Identifying associates 442
Use of equity method 443
Basis of equity method 444
Application of the equity method 446
Basic features
Identifying the share of the associate that belongs to the investor
Recognising the initial investment at cost
Recognising the dividends provided by the associate
Recognising the investor’s share of the associate post-acquisition other
Transactions between associate and investor (or its subsidiaries)
Investor’s share of losses
CONTENTS | 361
Disclosures for associates 458

Summary 459
Part D: Joint arrangements—overview 460
Appendix 463
Appendix 5.1 463
Assumed knowledge review 467

Assumed knowledge review questions 467
Assumed knowledge review answers 468
References 515
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Study guide | 363
Module 5:
Business combinations
and group accounting
Study guide
Preview
Introduction
As part of their strategic objectives, many entities get involved in investment activities to
grow or diversify their operations. Their investments can include:
• acquiring a business or some businesses of other entities (e.g. on 15 March 2016, Kogan.com
Pty Ltd (Kogan) acquired the online retail business of Dick Smith Holdings Ltd (Dick Smith))
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• establishing relationships with other entities through:
–– acquiring shares in other entities (e.g. on 1 January 2016, amaysim Australia Ltd (amaysim)
acquired the entire share capital of Vaya Pty Ltd (Vaya))
–– setting up joint arrangements (e.g. on 2 June 2016, Monash University and the
University of Melbourne formed a 50:50 joint venture in the field of biomedical research).
Each of those options comes with its own advantages and disadvantages. To ensure that the
strategic objectives of the investment can be achieved, due diligence must be performed when
making such investment decisions. For example, acquisition of a business with all its assets and
liabilities may be the most appropriate investment for an investor that needs to use the acquired
assets in its own business. Acquiring shares in other entities operating in growth markets with high
barriers to entry may be the most appropriate way for investors to gain exposure to those markets,
with the level of exposure sought influencing the level of equity interest acquired. Finally, setting up
joint arrangements may be an appropriate way to share scarce resources among business partners
in search of a common goal, while protecting themselves against a high level of risks.
When an entity has grown or diversified through either of these means, based on
the underlying principle of accounting it will need to prepare financial statements for
users to be able to understand the financial impact of those investments on the entity’s
financial position, performance and cash flows. In preparing the financial statements,
alternative accounting treatments are required, both at the time of the initial investment
and subsequently, according to the type of investment undertaken.
If these investments involve acquiring a business or some businesses of other entities,

the investor will directly get ownership over the assets and liabilities of the acquired
businesses; as such, the accounting treatment at the time of the initial investment and
subsequently will involve recognising those items in the investor’s own financial statements,
together with any other of its own assets and liabilities. For example, after Kogan acquired
the online retail business of Dick Smith, Kogan recognised the assets and liabilities acquired
in its own financial statements. Figure 5.1 shows a company acquiring two businesses that
become integral parts of the acquirer’s businesses.
Figure 5.1: Acquisition of multiple businesses by a company
Business Business
A A
Company Company
Business Business
B B

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If the investor establishes relationships with other entities through acquiring shares in
other entities or setting up a joint arrangement as a joint venture, the investor, in essence,
is acquiring a single asset: the investment account. As such, the accounting treatment at the
time of the initial investment will involve recognising the investment account in the investor’s
financial statements based on the consideration transferred. For example, after amaysim
acquired the share capital of Vaya, amaysim would recognise its investment in Vaya in an
investment asset account based on how much it paid for the shares acquired.
If the investor establishes relationships with other entities through setting up a joint
arrangement as a joint operation, it essentially acquires a share of the individual accounts
of the joint operation. As such, the accounting treatment at the time of the initial investment
will involve recognising in the investor’s financial statements the investor’s share of the individual
accounts. For example, if two entities establish a 50:50 joint operation that gives them joint
control over the assets and liabilities contributed to that operation, and one entity contributes
cash of $1 000 000 while the other entity contributes plant and equipment recognised at its fair
value of $1 000 000, each entity will recognise its share (50%) of the individual assets contributed
in their own financial statements (i.e. cash of $500 000 and plant and equipment of $500 000).
Study guide | 365
The subsequent accounting treatment of the relationships established with other entities
is dependent upon the type of relationship created. This module considers three types of
relationships established by the investor with other entities (shown in Figure 5.2):
1. parent–subsidiary relationship, established through investments where the investor (parent)
obtains control over other entities (i.e. wholly and partially owned subsidiaries, depending on
whether the parent has 100% of the shares in the subsidiary or less)
2. investor–associate relationship, established through investments where the investor obtains
significant influence over other entities (i.e. associates)
3. joint arrangements, established through investments where the investor obtains joint control
over other entities (i.e. joint operations and joint ventures, depending on whether the investor
has joint rights over the assets and liabilities of the arrangement or only over the net assets).
Figure 5.2: Types of relationships established by a company with other entities
Company
Associate
Significant
Control Joint control
influence
Wholly owned Partially owned Joint Joint

subsidiary subsidiary venture operation
There are nine international financial reporting standards that provide guidance on various
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aspects of accounting for these investment activities:
1. IFRS 3 Business Combinations—specifies the accounting requirements for acquisitions
of one or more businesses and for investments where the investor obtains control over
other entities.
2. IFRS 9 Financial Instruments—specifies the accounting requirements for investments
in shares and other financial instruments not covered by other accounting standards
that deal with specific types of investments (as listed in points 3, 4 and 6). (Note: IAS 32
Financial Instruments: Presentation and IFRS 7 Financial Instruments: Disclosures are also
relevant to the presentation and disclosures relating to investments in this category.)
3. IFRS 10 Consolidated Financial Statements—specifies the additional accounting
requirements for the preparation of consolidated financial statements for investments
where the investor obtains control over other entities.
4. IFRS 11 Joint Arrangements—specifies the accounting requirements for investments where
the investor obtains joint control over a joint arrangement that is either a joint operation
or a joint venture.
5. IFRS 12 Disclosure of Interests in Other Entities—specifies the disclosure of information
relating to investments in subsidiaries, associates, joint arrangements and unconsolidated
structured entities.
6. IAS 24 Related Party Disclosures—specifies the disclosure of information about relationships
and transactions with related parties including, among other parties, subsidiaries,
associates and joint arrangements.
7. IAS 27 Separate Financial Statements—specifies the accounting requirements for investments

in subsidiaries, associates and joint ventures when the investor prepares separate
8. IAS 28 Investments in Associates and Joint Ventures—specifies the accounting requirements
for investments in entities over which the investor has either significant influence (associates)
or that are regarded as joint ventures in IFRS 11.
9. IAS 40 Investment Property—specifies the accounting requirements for investments in
property held to earn rentals or for capital appreciation or both.
IFRS 9 will be dealt with in Module 6 and IAS 40 was briefly covered in Module 1. The remaining
accounting standards from the list above are addressed in this module, with discussion of the
overriding principles on which these accounting standards were developed. IAS 24 requires
disclosures regarding the effect of transactions between related parties (e.g. between parent
and subsidiary, investor and associate) to enable users to better assess the investor’s operations
and the risks and opportunities it may face, but it will not be discussed further as it is beyond the
scope of this material.
Part A of this module focuses on the general accounting principles and requirements applicable,
according to IFRS 3, to those investments where an investor acquires one or more businesses
(e.g. Kogan acquiring the online retail business of Dick Smith) or obtains control of other
entities (i.e. establishing a parent–subsidiary relationship). Those investments are denoted as
business combinations.
The remaining parts of this module focus solely on those relationships established by a company
with other entities, as per Figure 5.2. Part B of this module focuses on additional accounting
requirements prescribed in IFRS 10 for those investments where the investor obtains control
of other entities, giving rise to parent–subsidiary relationships. The additional requirements
addressed in Part B relate to the acquirer’s need to prepare consolidated financial statements to
show the financial performance, position and cash flows of the acquirer/parent and the subsidiary
from the perspective of the combined economic entity created. The Statement of Accounting
Concepts that forms part of the conceptual framework applicable in Australia (http://www.aasb.
gov.au/admin/file/content102/c3/SAC1_8-90_2001V.pdf) defines the term ‘economic entity’ as
‘a group of entities comprising a controlling entity and one or more controlled entities operating
together to achieve objectives consistent with those of the controlling entity’ (SAC 1, para. 6).
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The consolidated financial statements reflect the economic impact of transactions where the
economic entity as a whole is involved with external parties, but does not include the effect
of transactions within the economic entity—because the users of financial statements need to
know how well the entity is doing externally. Note that the accounting requirements from IFRS 3
described in Part A are applicable in the preparation of the consolidated financial statements
in accordance with IFRS 10.
Part C focuses on investments where the investor obtains significant influence over the investee
(associate). It addresses two issues in accordance with IAS 28:
1. determining whether or not that relationship exists
2. specifying the requirements for applying the equity method to account for investments
in associates.
Part D of this module provides a brief overview of the general principles and requirements
for those investments where the investor has joint control over a joint arrangement,
distinguishing between joint operations and joint ventures (IFRS 11).
Study guide | 367
Parts B, C and D also address the disclosure requirements for investors that have an investment
in subsidiaries, associates and joint arrangements, respectively. These requirements are
included in IFRS 12.
Table 5.1 provides a summary of the accounting treatment requirements for all the investment
types discussed previously (and illustrated by Figures 5.1 and 5.2), both at the time of the initial
investment and after.
Table 5.1: Accounting treatment of different investment types
Accounting
rules Section(s)
addressing addressing
this type of At the time of After the initial this type of
Investment type investment initial investment investment investment
Acquiring businesses IFRS 3 Recognise the assets Recognise the assets A

and liabilities of the and liabilities of the
business acquired business acquired
in the investor’s in the investor’s
accounts accounts
Obtaining control over IFRS 3, 10, 12; Recognise an Prepare A, B

other entities IAS 24 investment asset consolidated
in the investor’s financial statements
accounts
Obtaining significant IAS 24, 28 Recognise an Use the equity C

influence over other investment asset method of
entities in the investor’s accounting to
accounts recognise changes
in the investment
account
Setting up a joint IFRS 11, 12; Recognise an Use the equity D

venture IAS 24, 28 investment asset method of
in the investor’s accounting to
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accounts recognise changes
in the investment
account
Setting up a joint IFRS 11,12; Recognise the Recognise the D

operation IAS 24 investor’s share investor’s share
of the assets and of the assets and
liabilities of the joint liabilities of the
operation joint operation

Objectives
• identify a business combination, discuss the forms that it may take and analyse issues
relating to different business combinations;
• discuss and apply the acquisition method to a business combination, including the IFRS 3
requirements for recognising and measuring goodwill;
• apply the accounting for the deferred taxation impact of a business combination;
• explain the concept of control and analyse specific scenarios to outline how the existence
of control is determined;
• explain and prepare consolidation worksheet entries, including the revaluation of assets
subject to depreciation and transactions within the group;
• explain the concept of ‘non-controlling interest’ and prepare a consolidation worksheet
that includes the appropriate adjustment entries and allows for non‑controlling interests;
• explain and apply the disclosure requirements of both IAS 1 Presentation of Financial
Statements for consolidated financial statements and IFRS 12 Disclosure of Interests in
Other Entities for interests in subsidiaries, associates and joint arrangements;
• determine whether significant influence exists in specific scenarios and evaluate whether
consolidation is required;
• account for associates using the equity method; and
• define a joint arrangement and explain the accounting requirements of IFRS 11.
Teaching materials
International Financial Reporting Standards (IFRS), 2017 IFRS Standards (Red Book),
and the International Accounting Standards Board (IASB):
• IFRS 3 Business Combinations
• IFRS 10 Consolidated Financial Statements
• IFRS 11 Joint Arrangements
• IFRS 12 Disclosure of Interests in Other Entities
• IAS 12 Income Taxes
• IAS 27 Separate Financial Statements
• IAS 28 Investments in Associates and Joint Ventures
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• IAS 38 Intangible Assets
• Learning Tasks
Four Learning Tasks support this module. You can access them on My Online Learning.
Learning Task: Determination of goodwill
Learning Task: Pre-acquisition elimination
Learning Task: Intra-group transactions
Learning Task: Measurement of non-controlling interest
These Learning Tasks include a discussion of the principles of consolidation as well as providing the
opportunity for further practice.
Note that while the Learning Tasks provide valuable reinforcement of the module discussion, it is not
mandatory to use these resources.
Study guide | 369
Part A: Business combinations

Introduction
Many entities, no matter how big or small, at some point will try to expand by obtaining control
over other businesses, including whole entities, that is, via business combinations. Due to legal,
tax, regulatory or other reasons, a business combination may be structured in a variety of ways
(IFRS 3, Appendix B Application guidance, para. B6), including the following:
• An entity acquires the assets and liabilities of a business of another entity.
• An entity obtains control of another entity through the purchase of shares (equity interests)
in that entity.
• An entity obtains control of another entity through other means than the purchase of shares
(equity interests) in that entity (e.g. by contract alone).
• A new entity is formed to obtain control through the purchase of shares in other entities.
• A stapled entity is listed on the securities exchange. A stapled entity comprises several
legal entities that are stapled (combined) together so that purchasers of the ‘stapled’
shares become investors in all the legal entities (e.g. Westfield Group, which staples
together Westfield Holdings shares, Westfield Trust units and Westfield America Trust units).
• Dual-listed entities where the operations of two entities listed on different securities
exchanges are combined and managed via a contractual arrangement so that investors in
each of the entities share in the performance of the combined operations of both entities
(e.g. Rio Tinto Ltd in Australia and Rio Tinto plc in the United Kingdom).
This module considers the first two bullet points specified above, as these are two of the
most common scenarios. As in Figure 5.3, these two types of business combinations are
categorised as:
1. direct acquisition: acquiring the assets and liabilities (i.e. net assets) of another business
that does not represent a separate legal entity or subsequently ceases to exist as a separate
legal entity (e.g. the acquisition by Kogan of the online retail business of Dick Smith)
2. indirect acquisition: acquiring the shares of another separate legal entity in order to
obtain control over that entity, in which case a parent–subsidiary relationship arises
(e.g. the acquisition by amaysim of the entire share capital of Vaya).
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Figure 5.3: Business combinations
Business combinations
Investor acquires the assets and Investor acquires shares in another
liabilities of one or more businesses entity and obtains control
Direct acquisition Indirect acquisition

According to IFRS 3, where a business combination occurs, it is very important to first identify the
acquirer (i.e. the entity that obtains control, whether directly or indirectly), as it has to disclose
information that enables users to assess the nature and financial impact of the acquisition (in our
examples, the acquirers are Kogan and amaysim). Hence, IFRS 3 requires an acquirer to be
identified and the combination to be accounted for using the acquisition method. This method
results in information that shows the financial impact of the business combination on the acquirer
by identifying what was acquired in exchange for the consideration transferred. More specifically,
under this method, an acquirer recognises the identifiable assets acquired, liabilities assumed
and any non-controlling interests in the acquiree, and then identifies any difference at acquisition
date between:
(a) the fair value of the consideration transferred plus any non-controlling interest plus the fair
value of any previously held equity interest in the acquiree
(b) the fair value of the identifiable net assets acquired (IFRS 3, para. 32).
This difference will be recognised as goodwill if the amount in (a) is greater than the amount
in (b). If the opposite situation arises, the difference is considered to be a gain on bargain
purchase and recognised as part of profit or loss. As the latter is not common in practice,
this module will only focus on situations where goodwill arises as a result of a business
combination. IFRS 3 specifies measurement and disclosure requirements for goodwill,
both at the acquisition date and subsequently.
Note that the above formula for the calculation of goodwill essentially applies only in the case
of an indirect acquisition; in the case of a direct acquisition, there won’t be any non-controlling
interest or previously held equity interest in the acquiree and therefore the goodwill can be
calculated as the simple difference between the acquisition-date fair values of:
(a) the consideration transferred
(b) the identifiable net assets acquired.
When a business combination is an indirect acquisition (i.e. it involves a purchase of shares that
leads to a parent–subsidiary relationship), in accordance with the requirements of IFRS 10, a set
of consolidated financial statements must be prepared that include the aggregated (combined)
financial performance, financial position and cash flows of the parent and its subsidiary/ies.
The additional requirements related to the preparation of the consolidated financial statements
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are considered in Part B of this module.
Relevant paragraphs
To assist in understanding the material presented in Part A, you may wish to read the following
paragraphs of IFRS 3. Where specified, you need to be able to apply these paragraphs:
Subject Paragraphs
Objective 1
Scope 2
Identifying a business combination 3
The acquisition method 4–53
Identifying the acquirer 6–7
Determining the acquisition date 8–9
Recognising and measuring the identifiable assets acquired, liabilities assumed
and any non-controlling interest in the acquiree 10–31
Recognising and measuring goodwill or a gain from a bargain purchase 32–40
Measurement period 45–50
Determining what is part of the business combination transaction 51–3
Subsequent measurement and accounting 54–7
Disclosures 59–63
Defined terms Appendix A
Study guide | 371
Assumed knowledge
It is assumed that before commencing your study of Part A of this module, you are able to:
• understand the concept of cost of acquisition
• apply the cost method to a single asset, or a number of assets (but not a business).
Please note that the concepts considered as assumed knowledge are examinable.
Learning Task
For help in determining goodwill on acquisition, you can refer to the Learning Task:
Determination of goodwill on My Online Learning.
Note that while the Learning Task provides valuable reinforcement of the module discussion,
it is not mandatory to use this resource.
Identifying a business combination

A business combination is ‘a transaction or other event in which an acquirer obtains control
of one or more businesses’ (IFRS 3, Appendix A). Business combinations can be as simple as
buying a franchise from the franchisor, but also include transactions referred to as ‘true mergers’
or ‘mergers of equals’.
The business/es over which the acquirer obtains control is (are collectively) referred to as the
acquiree. A business is defined in Appendix A of IFRS 3 as an integrated set of assets (inputs)
and processes that may result in outputs reflecting economic benefits to be distributed to its
owners and other participants. For example, the online retail business of Dick Smith acquired by
Kogan on 15 March 2016 included the Dick Smith brand, its customer database, its domain name
and its website (to name a few of the inputs); those assets are used together to generate revenue
(i.e. outputs) through online sales.
It is important to note that the integrated set of assets and processes is required to be capable
of resulting in economic benefits to be recognised as a business and not actually required to
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produce these benefits yet. For example, a start-up entity that is still developing a product or is
trying to find a market for its products can still be classified as a business. Also, the assessment
of whether the assets and liabilities acquired constitute a business is based on the situation
existing at acquisition date; instances where those assets and liabilities are then sold to other
parties (i.e. essentially breaking up the business after acquisition) do not indicate that a business
combination did not take place at acquisition date, they just show that the business combination
was short-lived.
If you wish to explore this topic further you may now read the definitions of ‘acquirer’, ‘acquiree’,
‘business’, ‘business combination’ and ‘equity interests’ in IFRS 3, Appendix A, and ‘control’ in
paras 6–8, and ‘control of an investee’ in IFRS 10, Appendix A.
Now answer Question 5.1.

➤➤Question 5.1
Indicate which of the following acquisitions represent a business combination
Select one or more options from

the following list. Justify your answer for each option.
(a) A Ltd acquires inventory

from B Ltd on a regular
basis.
(b) A Ltd acquires plant and

equipment from B Ltd as a
one-off transaction.
(c) A Ltd acquires some

inventory from B Ltd that
it then sells to C Ltd and
some plant and equipment
that it then sells to D Ltd.
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(d) A Ltd acquires a bundle

of assets from B Ltd
that includes, among
others, cash, inventories,
a brand name, plant and
equipment, land and
buildings that are used
together to produce and
market a blood pressure
monitor.
(e) A Ltd acquires the entire

share capital of B Ltd from
its old shareholders.
Study guide | 373
The acquisition method

IFRS 3 requires that all business combinations, no matter the form, be accounted for using the
acquisition method. That is because the substance of these transactions (i.e. obtaining control
over other businesses) is the same; only the form varies. The acquisition method is applied
at acquisition date. As outlined in IFRS 3, para. 5, the application of the acquisition method
involves four steps:
(a) identifying the acquirer;
(b) determining the acquisition date;
(c) recognising and measuring the identifiable assets acquired, the liabilities assumed and
any non-controlling interest in the acquiree; and
(d) recognising and measuring goodwill or a gain from a bargain purchase.
It should be noted here that the acquisition method is consistent with the way accounting
in general deals with transactions in which assets are acquired and liabilities are assumed or
incurred (IFRS 3, para. BC24).
(a) Identifying the acquirer

The financial impact of a business combination is likely to be more significant for the entity that
obtains control in such a transaction or event, so the users of financial information need to focus
on the acquirer. Consequently, the acquisition method views the business combination from
the acquirer’s perspective, so it is fitting that the first step in applying this method is identifying
the acquirer. In the case of a direct acquisition, the acquirer is the entity that receives the assets
and liabilities acquired. In the case of an indirect acquisition, the guidance in IFRS 10 related to
the concept of control is used to identify the acquirer (IFRS 3, para. 7). As such, IFRS 10, para. 7
specifies the essential criteria of control that must be satisfied by the acquirer (investor) in order
to be considered as having control over the acquiree (investee), that is:
• power over the investee;
• exposure, or rights, to variable returns from its involvement with the investee; and
• the ability to use its power over the investee to affect the amount of the investor’s returns.
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It is normally assumed that an investor has control over the investee when it holds more than
50 per cent of the equity interests that carry voting rights in the investee. However, control can
exist even when the investor holds a lower percentage of those equity interests (e.g. when the
investor holds 49% of the equity interests that carry voting rights in the investee, while the other
51% is held by a few hundred individual shareholders, each holding less than 1%, who do not
regularly attend meetings where voting power can be exercised). The concept of control and
its application is discussed in detail in Part B of this module in the context of whether a parent–
subsidiary relationship exists.
Based on the guidance provided in IFRS 10 with regards to the criteria of control, determining
which entity is the acquirer in an indirect acquisition is a matter of professional judgment.
When the application of the guidance on control in IFRS 10 does not clearly indicate which
entity is the acquirer in an indirect acquisition, IFRS 3 includes additional guidance in
paras B14 –15 (see Table 5.2).
Table 5.2: Identifying an acquirer
Business combination effected The acquirer is usually
• primarily by transferring cash or other assets • the entity that transfers the cash or other assets
• by incurring liabilities • the entity that incurs the liabilities
• primarily by exchanging equity interests • the entity that issues the equity interests
Source: Adapted from IFRS Foundation 2017, IFRS 3 Business Combinations, paras B14–15,
IFRS 3 states that if a business combination involves an exchange of equity interests, the entity
issuing shares is normally the acquirer (IFRS 3, para. B15). Since this may not always be the case,
as in a reverse acquisition, all the facts and circumstances must be considered in assessing who
is the acquirer in a business combination.
Note: This module does not deal with accounting for reverse acquisitions considered in
IFRS 3, para. B19.
If you wish to explore this topic further you may now read IFRS 3, para. B15 to expand on the facts
and circumstances that should also be considered in identifying the acquirer in a business combination
effected by exchanging equity interests.
IFRS 3, paras B16 and B17 provide some additional guidance to assist in identifying the acquirer
in a business combination, including consideration of:
• the relative size of the combining entities, with the largest party normally being the acquirer
(e.g. when a large player in an industry decides to combine its business with one of its
competitors of considerably smaller size, it is normally assumed that the larger entity is the
acquirer, taking over the ‘little guy’)
• the entity that initiated the combination.
Further guidance in para. B18 specifies that a new entity formed to effect a business combination
is not necessarily the acquirer because this entity was created to manage the combined entities
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and did not play any part in the negotiations between the combining entities; instead, one of the
combining entities should be identified as the acquirer.
If you wish to explore this topic further you may now read the following paragraphs of IFRS 3:
• B16–18
• BC93–101, which discuss the IASB’s Basis for Conclusions on IFRS 3 in relation to identifying
the acquirer (Part B of the Red Book).

Study guide | 375
➤➤Question 5.2
Refer to the following business combinations and discuss the factors that need to be taken into
account when determining the acquirers in the combinations.
(a)
A Ltd B Ltd
A Ltd acquired 90%

of the shares and
voting rights in
B Ltd for cash.
(b)
D Ltd
100% 100% 100%
A Ltd B Ltd C Ltd
A new entity, D Ltd, was formed and acquired all

the shares in A Ltd, B Ltd and C Ltd by issuing
shares in D Ltd.
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(c) 100%
A Ltd B Ltd
Prior to the acquisition of shares in B Ltd, A Ltd had 500 000 shares on issue
(fair value of $5) and B Ltd had 400 000 on issue (fair value of $10).
To acquire the shares in B Ltd, A Ltd issued 800 000 shares to the shareholders of B Ltd.
(b) Determining the acquisition date

The acquisition date is the date on which the acquirer obtains control of the acquiree
(IFRS 3, para. 8). For a direct acquisition, that may be the date when the contract of the sale
of the business by the acquiree is signed. For an indirect acquisition, that may be the date when
enough shares in the acquiree that give majority voting power are held by the acquirer.
Example 5.1: Determining the acquisition date

As part of the history of the acquisition of B Ltd (B) by A Ltd (A), the following information is available
(assume that all the shares in B carry voting rights):
• On 15/08/20X1, A acquired 3.6 per cent of the shares in B.
• On 31/08/20X2, A acquired a further 18.9 per cent interest in B.
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• On 17/11/20X3, A managed to convince a major shareholder in B to sell its ownership interest

of 35.5 per cent to A, with the shares being transferred to A on that day.

We assume that there are no other facts and circumstances that may suggest when A controls B.
As such, we have to rely on the guidance that assumes that the party holding 50 per cent of the
voting rights has control. On 15/08/20X1, A had only 3.6 per cent of the voting rights in B, while on
31/08/20X2, the voting rights held by A increased to 22.5 per cent, which is still not enough to suggest
the existence of control. However, on 17/11/20X3, the interest by A becomes 58 per cent, enough to
give A control over B. As such, the acquisition date is 17/11/20X3. Figure 5.4 shows the timeline of the
events related to the acquisition of B’s shares by A and the total ownership interest by A at specific times:
Figure 5.4: Timeline for A’s acquisition of B’s shares

3.6% 22.5% 58%
01/01 01/01 01/01 01/01

20X1 20X2 20X3 20X4

Study guide | 377
Note: In the further examples and questions contained in this module, the acquisition date will
always be provided.
(c) R
ecognising and measuring the identifiable assets acquired,
the liabilities assumed and any non-controlling interest in
the acquiree
Recognition
In order to be recognised in a business combination, an identifiable asset or liability normally
needs to be one that is capable of being individually identified and separately recognised in
the statement of financial position because it meets the following recognition criteria:
• It meets the definition of an asset or liability in the Conceptual Framework at the
acquisition date.
• It must be part of what the acquirer and the acquiree exchanged in the business
combination transaction, rather than a result of separate transactions.
A number of exceptions to this principle are discussed shortly.
If you wish to explore this topic further you may now read IFRS 3, paras 10–14.
Identifiable assets acquired may include items such as inventory, receivables, property,
plant and equipment and intangible assets. If an acquired asset cannot be individually
identified and recognised (e.g. a customer list or employees’ satisfaction), by definition it is
regarded as part of the goodwill of the acquired business, which will be recognised in step 4
of the acquisition method.
Identifiable liabilities assumed may include, among others, items such as accounts payable,
loans and taxes payable.
Note that the recognition of the identifiable assets acquired and liabilities assumed is not limited to
the identifiable assets and the liabilities that were previously recognised by the acquiree. Given that
the acquisition method views the acquisition from the acquirer’s perspective, additional identifiable
assets or liabilities may be recognised in this step. For example, the acquiree may have some
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intangible assets that were generated internally—according to IAS 38, they may not be able to be
recognised by the acquiree prior to the business combination; however, they should be recognised
by the acquirer as part of the identifiable assets acquired as long as they satisfy either a:
• separability criterion, or
• contractual–legal criterion.
The separability criterion is fulfilled if the intangible asset can be separated from the entity
and sold, rented, transferred, licensed or exchanged. The contractual–legal criterion relates to
control over the asset via contractual or legal rights, regardless of whether or not the rights are
transferable or separable from the entity or other rights (IAS 38, para. 12; IFRS 3, para. B32).
Example 5.2: R
ecognising the identifiable assets acquired
and liabilities assumed
Assume that A Ltd (A) acquired the business of B Ltd (B), which ran a store in a sought-after location
that ensured customers enjoy shopping there. At acquisition date, the statement of financial position
prepared by B recorded the following assets and liabilities at fair value:
• accounts receivable—$400 000
• inventory—$600 000
• plant and equipment—$2 000 000
• land and buildings—$7 000 000
• accounts payable—$500 000
• bank loan—$4 500 000.
On top of that, A identified that B had a trademark with a fair value of $1 000 000 not recognised in
its financial statements. Also, customer satisfaction with B was extremely good due to the after-sale
service that B provided, and customers were willing to pay more for a product sold by B, even though
there were cheaper options available on the market.
When recognising the identifiable assets acquired and liabilities assumed, A will recognise the various
assets and liabilities already recorded by B prior to the acquisition, as well as the trademark not
previously recognised. The location of the store and the customer satisfaction may bring economic
benefits, but they cannot be separately identified and recognised; therefore, they may only be included
in the goodwill recognised on acquisition.
➤➤Question 5.3
The managing director of a company subject to a takeover offer argued that the price offered
by the potential acquirer was inadequate because it did not reflect the value of some items such
as the company’s brands, competitive position and market strength.
Which of these items could be recognised as an identifiable asset and which would form part of
‘goodwill’ in accordance with IFRS 3?
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Study guide | 379
The non-controlling interest is the equity in the acquiree/subsidiary that is not controlled by
the acquirer/parent. For example, a non-controlling interest would exist where the acquirer
owns 70 per cent of the issued capital of the acquiree. In this example, the non-controlling
interest shareholders own 30 per cent of the share capital of the acquiree. Note that the
non‑controlling interest in the acquiree is only recognised in business combinations structured
as indirect acquisitions.
Measurement
IFRS 3 requires that identifiable assets acquired and liabilities assumed are measured at their
acquisition date fair values (IFRS 3, para. 18). Adoption of this measurement basis by IFRS 3 is
necessary in order to capture the future cash flow potential resulting from the acquisition and
to provide more relevant information to users. For example, if an identifiable asset acquired
is measured based on its original cost, it may not reflect the true value of the asset from the
perspective of the acquirer (i.e. the amount it is willing to pay for it, which approximates the
amount of future economic benefits expected to be extracted from it); as such, the users may
be misled in their assessment of the potential benefits brought by the assets acquired.
For each business combination, the acquirer measures any non-controlling interest in the
acquiree either at:
• fair value, or
• the non-controlling interest’s proportionate share of the acquiree’s identifiable net assets
(IFRS 3, para. 19).
This decision of how to measure non-controlling interest is an accounting policy choice that the
acquirer is allowed to make on an acquisition-by-acquisition basis. The policy choice is important,
as the election impacts on the value of goodwill recorded (this will be discussed shortly).
Exceptions
IFRS 3 includes a number of exceptions to the recognition or measurement principles presented
above. These are summarised in Table 5.3. Note that an understanding of the specific recognition
and measurement requirements for each of these exceptions is not required for this module.
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Table 5.3: Exceptions to recognition or measurement principles
Exceptions to the recognition principle IFRS 3 requirements
• Contingent liabilities The acquirer shall recognise a contingent liability if it

is a present obligation that arises from past events and
its fair value can be measured reliably, even if it is not
probable. These requirements are contrary to IAS 37
Provisions, Contingent Liabilities and Contingent Assets.
Exceptions to the measurement principles IFRS 3 requirements
• Reacquired rights Measured on the basis of the remaining contractual

term of the related contract, regardless of whether
market participants would consider potential
contractual renewals.
• Share-based payment awards Measured in accordance with the method in IFRS 2

Share-based Payment.
• Assets held for sale Measured in accordance with IFRS 5 Non-current Assets
Held for Sale and Discontinued Operations.
Exceptions to both the recognition

and measurement principles IFRS 3 requirements
• Income taxes Recognised and measured in accordance with the

requirements of IAS 12 Income Taxes.
• Employee benefits Recognised and measured in accordance with

the requirements of IAS 19 Employee Benefits.
• Indemnification assets Recognised and measured on the same basis as

the indemnified item.
Source: Adapted from IFRS Foundation 2017, IFRS 3 Business Combinations,

If you wish to explore this topic further, you may now read IFRS 3, paras 21–31.
Example 5.3: R
ecognising and measuring the identifiable
assets acquired and liabilities assumed
In addition to the facts presented in Example 5.2, A Ltd (A) assumed a contingent liability disclosed
in the notes of the financial statements of B Ltd (B). This contingent liability related to a lawsuit by a
customer who fell in the store due to a slippery floor. Even though it was not probable that the lawsuit
would be lost as it was discovered that the customer was drunk at the time of the accident, A needed
to recognise it as part of the liabilities assumed as a result of the acquisition. The measurement of it
would be based on an estimation of potential damages awarded to the customer by the court.
➤➤Question 5.4
Would all identifiable assets and liabilities recognised by an acquirer be included in the statement
of financial position of the acquiree prior to acquisition?
MODULE 5
Study guide | 381
(d) R
ecognising and measuring goodwill or a gain from a
bargain purchase
Goodwill is measured at acquisition date as the fair value of the consideration transferred plus
the amount of any non-controlling interest, plus the fair value of any previously held equity
interest in the acquiree, less the fair value of the identifiable net assets acquired (IFRS 3,
para. 32). It represents future economic benefits other than those expected to arise from the
identifiable assets acquired and comprises assets that cannot be separately recognised and/or
sold (i.e. unidentifiable assets). Note that the existence of any previously held equity interest in
the acquiree implies an acquisition made in stages. While this module does not subsequently
address accounting for acquisitions made in stages, you need to be able to determine
goodwill where there is a previously held equity interest.
➤➤Question 5.5
Provide examples of unidentifiable assets that may contribute to the goodwill of a business.
MODULE 5
Identifying and measuring consideration
IFRS 3, para. 37 discusses how consideration transferred in a business combination is measured
at fair value, calculated as the acquisition-date fair values of the:
• assets transferred by the acquirer
• liabilities incurred by the acquirer with respect to the former owners of the acquiree
• equity interests issued by the acquirer.
Any acquisition-related costs incurred in a business combination are not considered part of the
consideration transferred. That is because these costs are incurred in separate transactions that
involved entities other than the acquiree or its owners. Those costs are required to be accounted
for as expenses in the period in which the costs are incurred with the exception of costs to issue
debt or equity securities, which are recognised in accordance with IAS 32 Financial Instruments:
Presentation and IFRS 9. Acquisition-related costs include finder’s fees; advisory, legal, accounting,
valuation and other professional or consulting fees; general administrative costs, including the costs
of maintaining an internal acquisitions department; and costs of registering and issuing debt and
equity securities (IFRS 3, para. 53).
• IFRS 3, para. 53, which discusses acquisition-related costs
• the definition of ‘fair value’ in IFRS 3, Appendix A.
Example 5.4: Identifying and measuring consideration

Assume that A Ltd (A) acquired all the assets and liabilities that constitute a business from B Ltd (B).
As part of the consideration transferred, A transferred the following:
• $1 000 000 in cash, with $400 000 raised from a debt issue that attracted 5 per cent interest per year
• other assets previously recorded by A at $300 000, but with a fair value of $500 000 at acquisition date
• shares in A that it issued with a value of $700 000, incurring $50 000 as share issue costs.
Note that A used the services of a financial adviser to help in the negotiations with B and paid
$150 000 for those services.
To identify and measure the consideration transferred, A needed to separate it from the
acquisition‑related costs. In this case, those costs were:
• interest incurred on the debt issue, which would be treated as a part of finance expenses
• share issue costs, which would be treated as a reduction in share capital
• remuneration of the financial adviser, which would be treated as part of expenses for the period.
In turn, consideration transferred would be recognised at fair value of $2 200 000, calculated as:
• $1 000 000 in cash
• $500 000 in other assets
• $700 000 in shares.
➤➤Question 5.6
(a) If an entity has an acquisitions department, would the costs associated with running
the department be included in the cost of a business combination?
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(b) On 1 April 20X5, Investor Ltd (Investor) signed an agreement to acquire all the shares of
Investee Ltd and, in return, to issue 100 000 of its own shares. The terms of the agreement
were fulfilled on 30 June 20X5, when the shares were transferred. Consulting fees relating
to the combination were $10 000. These costs were paid by Investor.
The last sale of Investor shares took place in December 20X4 at a price of $4.50 per share.
The estimated fair value of the shares at 30 June 20X5 was $5.00 per share.
Study guide | 383
(i) Calculate the consideration transferred for the investment acquired by Investor, explaining
your reasoning.
(ii) Provide pro forma journal entries for Investor to account for the acquisition of the
investment and the payment of the costs attributable to the investment.
Dr Cr
$000 $000
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Identifying and measuring non-controlling interest
As previously discussed, non-controlling interest is the equity in the acquiree not owned by
the acquirer. It represents an ownership interest in the acquiree by shareholders other than
the acquirer.
Also as previously mentioned, IFRS 3, para. 19 allows an accounting policy choice, on an
acquisition-by-acquisition basis, for the measurement of a non-controlling interest in
the acquiree. There are two options available to measure the non-controlling interest in
the acquiree at acquisition date:
1. ‘full goodwill’ method—at the fair value of the equity interests that the non-controlling
interest has in the acquiree
2. ‘partial goodwill’ method—at the non-controlling interest’s proportionate share of the fair
value of the acquiree’s identifiable net assets.
The measurement of the non-controlling interest at the fair value of the shares held by the
non‑controlling interest shareholders is known as the ‘full goodwill’ method. The reason for this
is that in the calculation of goodwill, the total fair value of the acquiree (i.e. subsidiary), being the
fair value of the consideration transferred by the acquirer plus the fair value of the non-controlling
interest plus the fair value of any previously held interest by the acquirer, is compared with the
total fair value of the identifiable net assets in the acquiree. The difference is ‘full goodwill’.
In essence, this method measures the total goodwill of the business combination at acquisition
date, including:
• goodwill for the acquirer, calculated as the fair value of the consideration transferred by the
acquirer plus the fair value of any previously held interest by the acquirer minus the acquirer’s
proportionate share of the fair value of the acquiree’s identifiable net assets
• goodwill for the non-controlling interest, calculated as the fair value of the equity interests
that the non-controlling interest has in the acquiree minus the non-controlling interest’s
proportionate share of the fair value of the acquiree’s identifiable net assets.
Where the non-controlling interest is measured using its proportionate share of the acquiree’s
identifiable net assets, essentially only the acquirer’s share of the goodwill is recognised in the
business combination (see ‘goodwill for the acquirer’ bullet point above for a discussion of
calculation). For this reason, this second choice is referred to as the ‘partial goodwill’ method.
Under this method, the value assigned to the non-controlling interest is lower than under the full
goodwill method because it does not recognise any goodwill for the non‑controlling interest.
It is important to note that the per-share fair value of the non-controlling interest in the acquiree
cannot be measured based on the per-share fair value of the consideration transferred by the
acquirer at acquisition date. The per-share fair value of the consideration transferred by the
acquirer at acquisition date may include a control premium that the acquirer is willing to pay on
top of the normal per-share fair value of the shares in the acquiree to gain control; alternatively,
the per-share fair value of the non-controlling interest in the acquiree may include a discount,
as those shares do not give control as control rests with the acquirer (IFRS 3, para. B45).
Example 5.5 illustrates how goodwill is calculated with a non-controlling interest applying the
two options permitted by IFRS 3, para. 19.
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Example 5.5: C
alculation of goodwill with non-controlling
interest
On 1 July 20X7, Entity A acquired 30 per cent of the shares in Entity B for $30 000. On 1 July 20X8,
Entity A acquired a further 50 per cent interest in Entity B for $77 000, which gave it control. Entity B
has 140 000 shares issued, with a fair value of $1 per share. At 1 July 20X8, the fair value of Entity B’s
identifiable net assets is $110 000.
Goodwill at 1 July 20X8 is calculated as follows:

NCI calculated as
a percentage of
NCI calculated fair value of
at fair value of identifiable net
equity interests assets (partial
held (full goodwill) goodwill)
Fair value of consideration transferred by acquirer 77 000 77 000
Non-controlling interest (20%)† 28 000 ‡ 22 000 §
Fair value of previously held interest by acquirer (30%) 42 000 42 000 ||
147 000 141 000
Fair value of identifiable net assets in Entity B 110 000 110 000
Goodwill 37 000 31 000
Study guide | 385
NCI = non-controlling interest

†
The NCI at 1 July 20X8 is 20 per cent given that Entity A has an 80 per cent interest (30 per cent previously
held plus 50 per cent acquired on 1 July 20X8) in Entity B.
‡
Under the full goodwill method, the NCI is measured as the fair value of the equity interests that the NCI
has in Entity B: 20% × 140 000 shares @ $1 per share = $28 000.
§
Under the partial goodwill method, the NCI is measured as the proportionate share of the fair value of
Entity B’s identifiable net assets (20% × $110 000 = $22 000).
||
The fair value at 1 July 20X8 of the previously held interest of 30 per cent that Entity A had in Entity B is
30% × 140 000 shares @ $1 per share = $42 000.
Example 5.5 demonstrates how goodwill can differ, depending on the method used to measure
the non-controlling interest. In this case, the difference between goodwill recognised under the
full goodwill method (i.e. $37 000) versus the partial method (i.e. $31 000) is $6000, which also
represents the difference between the fair value of the equity interests that the non-controlling
interest has in the acquiree (i.e. $28 000) and the non-controlling interest‘s proportionate share of
the fair value of the acquiree’s identifiable net assets (i.e. $22 000)—this difference is essentially
the goodwill for the non-controlling interest.
Note also that the per-share fair value of the non-controlling interest (i.e. $1.00) is different
from the per-share fair value of the consideration transferred by the acquirer (i.e. $77 000
/ (50% ×140 000) = $1.10) as the consideration transferred includes a control premium of
$0.10 per share.
Non-controlling interest is addressed in more detail later in Part B of this module when
IFRS 10 is discussed. For the remainder of Part A, goodwill is calculated as the consideration
transferred less the fair value of the identifiable net assets acquired.
If you wish to explore this topic further you may now read IFRS 3:
• paras 32–3
• paras B44 and B45, which expand on the discussion regarding the acquiree’s
non‑controlling interest.
Measurement and recording of goodwill subsequent to the date of purchase

Goodwill is not permitted to be amortised and, instead, it is required to be tested annually for
impairment in accordance with IAS 36. As a consequence, subsequent to the date of purchase,
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goodwill will be adjusted for impairment losses (IFRS 3, para. B63(a)). Impairment of goodwill
is discussed in Module 7.
Applying the acquisition method to different

forms of business combinations
It is important to note that the form of business combination creates accounting differences
when applying the acquisition method, as the subsequent discussion will highlight.
1. Direct acquisition: purchase of assets and liabilities of a business

Acquiring the assets and liabilities constituting a business results in transferring these
items directly to the acquirer, which can use them in its own business, generally without any
restrictions imposed by other parties. As such, the acquirer will need to recognise them in
its financial statements in a similar way to an acquisition of individual assets. One distinction,
however, is when the business acquired includes unidentifiable assets like customer relationships
or employee morale—unidentifiable assets can only be recognised if acquired as part of a
business, in which case they will be collectively recognised under goodwill acquired.
As previously mentioned, it is important to note that the assets and liabilities acquired as part
of a business may also include identifiable assets and liabilities previously not recognised by the
acquiree. From the acquirer’s perspective, those assets and liabilities represent items that it now
owns and, therefore, they need to be separately recognised.
Example 5.6: A
pplying the acquisition method for
a direct acquisition
Refer to the data in Example 5.2. Assuming that the consideration transferred by A Ltd (A) to acquire
all the assets and liabilities in B Ltd (B) was $8 000 000 paid in cash, A would have to recognise goodwill
(presumably attributable to B’s store location and customer satisfaction) as the difference between
the fair value of consideration transferred and the fair value of the identifiable net assets in B. The fair
value of the identifiable net assets in B would be calculated as:
Fair value of total identifiable assets recorded by B $10 000 000

Add: Fair value of identifiable assets not previously recorded by B $1 000 000
Less: Fair value of total identifiable liabilities in B ($5 000 000 )
Fair value of total identifiable net assets of B $6 000 000
Therefore, the goodwill on acquisition is:

Fair value of consideration transferred by acquirer $8 000 000
Less: Fair value of total identifiable net assets in B ($6 000 000 )
Goodwill $2 000 000
The journal entry posted by A in its own records to recognise the acquisition of all the assets and
liabilities of B would be as follows:
Dr Cr
$ $
Account receivable 400 000
Inventory 600 000
Plant and equipment 2 000 000
Land and buildings 7 000 000
Trademark 1 000 000
Goodwill 2 000 000
Account payable 500 000
Bank loan 4 500 000
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Bank 8 000 000
➤➤Question 5.7
Using the same data as in Example 5.6 and assuming that a contingent liability exists in the notes
of B as suggested in Example 5.3 (A measures it at the fair value of $1 000 000), prepare and
explain the journal entry posted by A to recognise the acquisition of the assets and liabilities of
B. Assume no tax effect.
Study guide | 387
2. Indirect acquisition: Purchase of shares (i.e. equity interests) of an entity

Acquiring the equity interests of another entity that gives the acquirer control over that other
entity results in the acquirer in essence purchasing a single asset: an investment in the shares of
the acquiree. As such, the acquirer can only recognise this new asset in its financial statements.
However, this type of acquisition results in a parent–subsidiary relationship, with the acquirer
being the parent and the acquiree being the subsidiary. This relationship gives rise to the need
to prepare a set of consolidated financial statements for the group of entities, which includes
the parent and its subsidiary, to provide users with information about the combined financial
performance, position and cash flows of the group. The consolidated financial statements
will include the assets and liabilities of the subsidiary in a similar way as they would have
been recognised in the acquirer’s statements if they were directly acquired by the acquirer.
That means that the consolidated financial statements need to recognise:
• any unidentifiable assets like customer relationships or employee morale as goodwill
acquired
• any identifiable assets and liabilities previously not recognised by the acquiree.
If the acquirer in an indirect acquisition is required to present separate financial statements,

IAS 27, para. 10 states that the investment in the shares of the acquiree should be accounted
in the financial statements of the acquirer/parent either:
• at cost, or
• in accordance with IFRS 9.
If you wish to explore this topic further you may now read IAS 27:
• para. 4, the definition of ‘separate financial statements’
• para. 10 (assume that the investment is not classified as held for sale).
Note: The examples and questions in Module 5 assume that the parent carries the investment in its
financial statements at cost.
Example 5.7: A
pplying the acquisition method for an
indirect acquisition
Using the same data as in Example 5.6, but assuming that A Ltd (A) acquired all the shares in B Ltd (B)
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instead of directly acquiring the assets and liabilities, the journal entry posted by A in its own accounts
to recognise the business combination would be as follows:
Dr Cr
$ $
Investment in B 8 000 000
Bank 8 000 000
Note that the amounts recognised under the acquisition method for all the identifiable assets and
liabilities of B at acquisition date and for the goodwill will be exactly the same as in Example 5.6.
However, only the consolidated financial statements, where those items will be recognised, will reflect
those values; A cannot recognise those items in its own financial statements as it did not acquire them
directly—A only acquired directly the investment in shares.

➤➤Question 5.8
Refer to the journal entries posted in Examples 5.6 and 5.7. Discuss the impact of those entries
of the individual accounts of A and identify which one provides more information to the users
interested in B.
Please note that notwithstanding these differences discussed above, both forms of business
combinations still comply with the requirement in IFRS 3 to account for a business combination,
no matter its form, by applying the acquisition method. Those differences just mean that the
acquisition method is applied:
• in the acquirer’s own financial statements in the case of a direct acquisition
• in the consolidated financial statements in the case of an indirect acquisition.
Deferred tax arising from a business

combination
Deferred tax related to assets and liabilities acquired in
a business combination
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As discussed, IFRS 3 requires identifiable assets and liabilities acquired in a business combination
to be measured at fair value at acquisition date. As such, temporary differences arise when the
tax base of the asset acquired or liability assumed is either not affected, or is affected differently
compared to the carrying amount, by the business combination (IAS 12, para. 19). For example,
in an indirect acquisition, assume equipment of the acquiree/subsidiary is recognised at its fair
value of $100 000 at acquisition date. The carrying amount and tax base prior to the acquisition
was $70 000, and the tax base does not change as a result of the revaluation on acquisition.
This would give rise to a taxable temporary difference of $30 000 at acquisition date calculated
as the difference between the new carrying amount and the tax base (the concepts of tax
base and temporary difference were discussed in Module 4). As a result, the acquirer would
recognise a deferred tax liability of $9000 (assuming a tax rate of 30%) as part of the liabilities
assumed. As another example, in a direct acquisition this time, an acquirer recognises an
assumed provision for warranty expenses from an acquired business. The fair value of this
provision is $50 000, which is recognised as the carrying amount in the statements of the acquirer.
For tax purposes, the warranty costs will only be deductible when the entity pays the claims and
therefore the tax base is nil. Compared to the carrying amount, this gives rise to a deductible
temporary difference of $50 000, for which the acquirer will have to recognise a deferred tax
asset of $15 000 as part of the assets acquired (assuming a tax rate of 30%).
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Recognising additional deferred tax assets and liabilities in a business combination affects the
amount of goodwill recognised (IAS 12, paras 19 and 66). The fair value of the identifiable net
assets will increase (if a deferred tax asset is recognised) or decrease (if a deferred tax liability
is recognised). This impacts on the goodwill—that is, the difference between the fair value of
the consideration transferred and the fair value of the identifiable net assets.
While deferred tax assets and liabilities can arise from measuring identifiable assets and liabilities
at fair value in a business combination, IAS 12 prohibits the recognition of a deferred tax liability
arising from goodwill (IAS 12, paras 15 and 21). This is because goodwill is a residual, and, as such,
creates a mutual dependence between the recognition of a deferred tax liability relating to it and
its measurement. As a deferred tax liability is an identifiable liability, recognition of a deferred tax
liability for goodwill would decrease the fair value of the identifiable net assets by the amount of
the deferred tax liability, which then increases the amount of goodwill. This would create the need
to reassess the amount of deferred tax liability relating to goodwill and so on in an endless loop.
If you wish to explore this topic further you may now read IAS 12, paras 15, 21 and 66.
Deferred tax related to tax losses in a business combination

As a result of a business combination, the acquirer may recognise a deferred tax asset for tax
losses that it had previously considered not recoverable. For example, tax losses of the acquirer
may now be able to be offset against future taxable profit of the acquiree. As it relates to tax
losses of the acquirer, the deferred tax asset recognised cannot be identified as part of the assets
acquired and therefore does not impact on goodwill (IAS 12, para. 67).
At the date of a business combination, an acquiree may have potential benefits from tax losses
or other deferred tax assets. If the acquirer considers it is probable that these benefits will be
realised, it will recognise them as part of the assets acquired; hence, they are taken into account
when determining goodwill. However, if the acquirer considers that it is not probable that those
potential tax benefits of the acquiree would be realised after acquisition, it won’t recognise
them as part of the business combination. Nevertheless, if those unrecognised tax benefits of
the acquiree are eventually realised after acquisition, IAS 12, para. 68(b) requires the acquirer to
recognise them in the statement of profit or loss (P&L) (or in other comprehensive income (OCI)
if those tax benefits relate to items recognised in OCI according to para. 61A).
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If you wish to explore this topic further you may now read IAS 12, paras 66–8. Note: You will not be
required to deal with the application of the requirements of IAS 12, para. 68 for deferred tax assets
not recognised at the acquisition date.
Example 5.8: P
urchase of a business from another entity
with no deferred tax effects
On 1 January 20X7, Large Ltd (Large) agreed to purchase the assets and liabilities of Small Ltd (Small)
for $400 000 cash plus 50 000 ordinary shares in Large. The shares of Large were currently traded on
the stock exchange for $4.50 each. It was not expected that the proposed issue would affect this price.
The statement of financial position for Small at the date of purchase is presented here.
Small: Statement of financial position as at 1 January 20X7
Assets $000 Liabilities $000 $000

Trade receivables 100 Bank overdraft 30
Inventory 220 Trade payables and loans 400 430
Land and buildings Equity
(net of accumulated depreciation) 630 Retained earnings 420
Issued capital 100 520
950 950
To determine goodwill, it is first necessary to measure the fair value of the consideration transferred.
In this case, that is equal to $625 000 calculated as:
$000
Cash 400
Fair value of shares issued (50 000 @ $4.50) 225
Fair value of consideration transferred 625
Next, the acquisition date fair values of the identifiable assets acquired and liabilities assumed
are considered. Large has determined the following fair values:
$000
Trade receivables 95
Inventory 200
Land and buildings 700
Bank overdraft (30 )
Trade payables and loans (400 )
Fair value of identifiable net assets 565
As the assets were acquired by Large in a direct acquisition, it is assumed that the amount they were
initially recognised at establishes their tax base for Large. In addition, it is assumed that there are no
taxable or deductible temporary differences arising from the acquired liabilities, as their tax base and
fair value (i.e. carrying amount) are equal due to their nature. Hence, Large does not need to recognise
a deferred tax asset or liability from the business combination.
The goodwill purchased by Large can now be measured in accordance with IFRS 3, para. 32 as follows:
$000
Fair value of consideration transferred 625
Less: Fair value of identifiable net assets (565 )
Goodwill 60
The goodwill of $60 000 will be recognised in the statement of financial position of Large as
a non‑current asset.

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➤➤Question 5.9
Prepare a pro forma general journal entry to reflect the acquisition of Small’s assets and liabilities
by Large, based on the data in Example 5.8.
Dr Cr
$000 $000
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Notes:
In Example 5.8, the tax bases of each of the assets were considered to be equal to their fair
values and there were no taxable or deductible temporary differences arising from the acquired
liabilities given their nature, so no tax effect was recorded. Example 5.9 deals with a scenario
where the tax bases differ from the fair values of the net assets acquired.
Example 5.9: P
urchase of a business from another entity
with deferred tax effects
On 1 July 20X6, High Ltd (High) purchased the business of Low Ltd (Low). The consideration transferred
was $2 800 000 in cash.
Low disclosed in the notes to its financial statements a contingent liability with a fair value of $300 000.
The liability was contingent, as it was not probable that an outflow of resources would occur and,
therefore, was not recognised as a liability prior to the acquisition. On acquisition, in accordance with
IFRS 3, High recognised a liability for this contingent liability in its statement of financial position,
even though it was not probable. In addition, as the tax base of this liability was $0 (carrying amount
$300 000 less future deductible amount of $300 000), there was a deductible temporary difference of
$300 000. Therefore, a deferred tax asset of $90 000 ($300 000 × 30%) also had to be recognised by
High in relation to this provision as part of the accounting for the business combination.
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Apart from the contingent liability, and the related deferred tax asset, High had determined that the
fair values of the other identifiable net assets of Low at the acquisition date included:
$000
Inventory 850
Plant and equipment 2 600
Trade payables (100 )
Loans (890 )
2 660
It is assumed that on the acquisition of the previously recognised assets, the tax base will be equal
to their fair values and no deferred assets or liabilities will be recognised in relation to them. Also,
there are no taxable or deductible temporary differences arising from the acquired liabilities that were
previously recognised by Low given their nature.
Therefore, the fair value of the identifiable net assets in Low at the acquisition date would be determined
as follows:
$000
Fair value of previously recognised identifiable net assets 2 660
Less: Fair value of contingent liability (300 )
Add: Deferred tax asset relating to contingent liability 90
Fair value of identifiable net assets in the acquiree 2 450
The goodwill would be calculated as follows:

$000
Fair value of the consideration transferred 2 800
Less: Fair value of identifiable net assets in the acquiree (2 450 )
Goodwill 350
➤➤Question 5.10
Based on the data in Example 5.9, prepare a pro forma journal entry for High to reflect the
acquisition of Low’s assets and liabilities.
Dr Cr
$000 $000
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Notes:
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Disclosures: Business combinations

IFRS 3 includes extensive disclosure requirements to enable financial statement users to evaluate
the financial effects of the acquirer’s business combinations that occur either during the current
reporting period or after the end of the reporting period, but before the financial statements
are authorised for issue. IFRS 3, para. 61 also requires disclosures to enable users to evaluate the
financial effects of adjustments recognised in the current reporting period that relate to business
combinations that occurred in the current period or previous reporting periods.
If you wish to explore this topic further you may now read IFRS 3, paras 59–63 and B64–7,
which detail the specific disclosure requirements of IFRS 3.
Summary
IFRS 3 specifies the requirements for accounting for business combinations that involve an
acquirer obtaining control of another business (or businesses). This part of the module considered
two common approaches to undertaking a business combination:
1. direct acquisition: purchasing the assets and liabilities that constitute a business from
another entity
2. indirect acquisition: acquiring the shares of another entity to obtain control over that entity.
In accordance with IFRS 3, all business combinations must be accounted for by using the
acquisition method, which involves four steps:
1. identifying the acquirer
2. determining the acquisition date
3. recognising and measuring the identifiable assets acquired, the liabilities assumed
and any non‑controlling interest in the acquiree
4. recognising and measuring goodwill or a gain from a bargain purchase.
The acquisition method requires the acquirer of a business to recognise the assets acquired
and liabilities assumed at their acquisition date fair values. If the combination involves acquiring
control of another entity via the acquisition of shares in that entity (i.e. indirect acquisition) and the
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acquirer does not acquire all of the shares in the subsidiary, the non-controlling interest also needs
to be measured at acquisition date. IFRS 3 permits the non-controlling interest to be measured
either at fair value or by using its proportionate share of the subsidiary’s identifiable net assets.
After measuring the identifiable net assets acquired and the non-controlling interest, the acquirer
measures the difference between:
• the acquisition date fair value of the consideration transferred plus any non-controlling
interest plus the acquisition date fair value of any previously held equity interest in the
acquiree, and
• the acquisition date fair value of the identifiable net assets in the acquiree.
While the difference will generally be recognised as goodwill, in rare instances there may be
a gain from a bargain purchase that must be recognised in profit or loss.
When a combination involves a purchase of assets and liabilities that constitute a business
(i.e. direct acquisition), IFRS 3 is to be applied in the acquirer’s financial statements. When a
combination involves a purchase of shares that leads to a parent–subsidiary relationship
(i.e. indirect acquisition), a set of consolidated financial statements must be prepared in
accordance with the requirements of IFRS 10. IFRS 10 is dealt with in Part B. IFRS 3 is to be
applied in the consolidated financial statements.
Deferred tax effects can arise as a result of a business combination due to:
• the revaluation of identifiable assets and liabilities to fair value at acquisition date
• the recognition of recoverable tax losses or other tax credits.
IFRS 3 includes disclosure requirements to enable financial statement users to evaluate the
financial effects of the acquirer’s business combinations that occurred during the reporting
period or after the end of the reporting period, but before the financial statements are
authorised for issue.
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Part B: Consolidated financial

statements
Introduction
Part A of this module dealt with the accounting requirements for business combinations
in general (i.e. arising from direct and indirect acquisitions). Part B deals with the specific case
of an indirect acquisition and examines additional accounting requirements for the preparation
of consolidated financial statements. It examines IFRS 10 and the disclosure requirements for
interests in subsidiaries contained in IFRS 12.
IFRS 10 is concerned with establishing the principles for the preparation and presentation of
financial statements of a group when an investment by the investor in another entity creates
a parent–subsidiary relationship. These consolidated financial statements present the assets,
liabilities, equity, income, expenses and cash flows of the parent and its subsidiaries as those
of a single economic entity (as opposed to legal entity) (IFRS 10, para. 1 and definition of
‘consolidated financial statements’ in Appendix A). Consolidated financial statements are
useful to various financial statement users, both internal and external to the economic entity.
Senior management and board directors of the parent entity are interested in understanding the
contribution of the acquiree’s (i.e. subsidiary’s) activities to group performance. Consolidated
financial statements provide this information by reporting the post-acquisition results of the
subsidiary and the complete results of the acquirer (i.e. the parent). External users, such as
existing and potential investors, analysts and creditors are also interested in understanding
the subsidiary’s contribution to group performance. Such interest might be particularly so
in the first year or two after acquisition.
IFRS 12 applies to entities that have an interest in one of the following: subsidiaries, joint
arrangements, associates or unconsolidated structured entities (IFRS 12, para. 5). If an entity
has an interest in subsidiaries, the standard requires the entity to disclose information
that enables users to evaluate the nature of, and risks associated with, its interests in the
subsidiaries, and the effects of those interests on its financial position, financial performance
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and cash flows (IFRS 12, para. 1). To achieve this objective, IFRS 12 requires disclosure of
information concerning:
• significant judgments and assumptions in determining that the entity has control of
another entity
• details of an entity’s interests in subsidiaries, which include details such as the composition
of the group and non-controlling interests’ share of the group’s performance and cash flow.
Relevant paragraphs
To assist you in achieving the objectives for this Part B of this module, you may wish to read the
following paragraphs of IFRS 10 and IFRS 12. Where specified, you need to be able to apply
these paragraphs.
Subject Paragraphs
IFRS 10 Consolidated Financial Statements
Objective 1–3
Scope 4
Control 5–9
Power 10–14
Returns 15–16
Link between power and returns 17–18
Accounting requirements 19–24
Determining whether an entity is an investment entity 27–30
Investment entities: Exception to consolidation 31–3
Defined terms Appendix A
Application guidance Appendix B
Assessing control B2–28, B34–50, B55–72
Consolidation procedures B86
Uniform accounting policies B87
Measurement B88
Potential voting rights B89–91
Reporting date B92–3
Non-controlling interests B94–5
IFRS 12 Disclosure of Interests in Other Entities

Objective 1–4
Scope 5
Significant judgements and assumptions 7–9
Interests in subsidiaries 10–19
Application guidance B10
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Assumed knowledge
It is assumed that before commencing Part B of this module, you are able to:
• understand the concept of consolidated financial statements
• understand the design and purpose of a consolidation worksheet (Note: A consolidation
worksheet is prepared each financial year using the financial information of the parent entity
and its subsidiaries. Accordingly, the adjustment entries in the consolidation worksheet do
not carry over from period to period, and must be determined and incorporated into the
consolidation worksheet each financial year)
• determine whether an acquisition of a subsidiary involves purchased goodwill or a gain
on bargain purchase (Note: Only purchased goodwill will be addressed in this module)
• prepare a consolidation pre-acquisition elimination entry at the acquisition date that
involves the revaluation of assets and recognition of goodwill
• prepare consolidation worksheet entries to eliminate intra-group transactions,
excluding tax effects.
To help you test your understanding of some aspects of assumed knowledge, two questions
are included in the ‘Assumed knowledge review’ at the end of this module. It is strongly
recommended that you answer these questions when directed to do so.
Please note that concepts considered as assumed knowledge are examinable.

Study guide | 397
Learning Tasks on My Online Learning

The Learning Tasks deal with the assumed knowledge for the module and other selected module
topics. You should integrate the Learning Tasks into your study of this module by using them to
consolidate concepts and for further practice.
Note that while the Learning Tasks provide valuable reinforcement of the module discussion, it is not
mandatory to use these resources.
Introduction to consolidated financial statements

The purpose of consolidated financial statements is to disclose the financial performance,
position and the cash flows of a group of interrelated entities that operate as a single economic
entity (but not a single legal entity). IFRS 10 is primarily concerned with establishing the principles
for the preparation of consolidated financial statements.
According to SAC 1 (http://www.aasb.gov.au/admin/file/content102/c3/SAC1_8-90_2001V.pdf),

the term ‘economic entity’ means a ‘group of entities comprising a controlling entity and one or
more controlled entities operating together to achieve objectives consistent with those of the
controlling entity’ (SAC 1, para. 6).
In essence, the overriding principle that applies in the preparation of consolidated financial
statements is that these statements need to show how the financial position, financial
performance and cash flows of the group are impacted by transactions with other entities.
As the entities within the group are considered an integral part of the group, the investments
between themselves and the effect of transactions between them (i.e. intra‑group transactions)
should be eliminated. A group can be thought of as similar to a single company that has
numerous departments. As the company does not disclose in its financial statements the
effect of transactions between internal departments, a group should not disclose, for example,
intra‑group investments, intra-group receivables and payables or intra‑group profits and losses.
This is because, as a single entity, the group cannot have investments in itself, receivables from
itself, payables to itself or profits and losses generated from within. The consolidated financial
statements should recognise the assets, liabilities, equity, income, expenses and cash flows of
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all the entities within the group as they are impacted by transactions with external parties only.
The consolidated financial statements are prepared in order to provide easy-to-access information
about the group’s risks and opportunities that would otherwise be difficult to assess if only the
separate financial statements of the entities within the group were prepared. Also, by eliminating
the effects of intra-group transactions that may not be at arm’s-length prices (instead at prices that
may benefit an entity in the group to the detriment of the other in order to shift some income,
expenses, assets or liabilities), external parties looking to transact with an entity get a better
understanding of the true financial position and performance of the group. For example, lenders
to an entity within the group may not only be interested in the financial position and performance
of that entity, but may also be interested in the financial position and performance of the whole
group to assess whether the borrower will be able to pay back the debts when they fall due.
For the purpose of this module, the terms ‘economic entity’ and ‘group’ have the same meaning and
are interchangeable. If you wish to explore this topic further you may now read IFRS 10, paras 1–3,
which discuss the objective of the standard. You may also wish to review the following definitions in
IFRS 10, Appendix A:
• ‘parent’
• ‘subsidiary’
• ‘group’
• ‘consolidated financial statements’.
In determining which entities are part of a group, the standard relies on the criterion of control.
If one entity controls another entity, a ‘parent–subsidiary’ relationship is deemed to exist. IFRS 10
requires parent entities to prepare a single set of consolidated financial statements for the group
unless it satisfies certain restrictive conditions that are outlined in para. 4 of the standard.
Broadly, IFRS 10 is concerned with two issues:

1. defining the group
2. preparing consolidated financial statements.
As indicated in Part A of this module, IFRS 3 is relevant to the second of these issues.
The group
Defining the group
Where one entity controls another entity, this gives rise to a parent–subsidiary relationship and
establishes a group for financial reporting purposes (IFRS 10, Appendix A ‘Defined terms’).
The focus of reporting (the group or economic entity) can be visualised as in Figure 5.5.
Figure 5.5: Concept of the group
GROUP
Parent Subsidiary
Controls
entity entity
A group can be of different shapes and sizes, and while it may include a minimum of two entities,
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there is no upper limit of how many entities can form a group. The entities within the group may
be listed on a stock exchange or not.
As indicated in the diagram, ‘control’ is used to define the group. Specifying control as the
criterion for the need to prepare consolidated financial statements has several important
consequences, including:
• the legal form of the members of the economic entity is irrelevant
• equal applicability in both the public and the private sectors
• a broad concept of group (the nature of the entity or lack of ownership rights is not
a limiting factor).
It should not be inferred that the use of control implies that information concerning ownership
interest lacks relevance to users. For this reason, information concerning the levels of equity
attributable to the ownership group of the parent entity and to the non-controlling interest
is disclosed.
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Concept of control
IFRS 10 requires that consolidated financial statements be prepared where a parent entity
controls an investee (i.e. a subsidiary entity). IFRS 10 (para. 7) specifies the three essential criteria
of control, all of which must be satisfied by the investor in order to be considered to have control
over the investee:
1. ‘power over the investee’
2. ‘exposure, or rights, to variable returns from its involvement with the investee’
3. ‘the ability to use its power over the investee to affect the amount of the investor’s returns’
(IFRS 10, para. 7).
The concept of control can be understood as shown in Figure 5.6.
Figure 5.6: The essential attributes of control

Ability to use power to affect the
investor’s variable returns
Power Variable returns
Professional judgment has to be exercised when assessing whether or not control exists,
and the assessment must take into account all facts and circumstances (IFRS 10, para. 8).
Significant judgments and assumptions made in determining whether control exists must be
disclosed in accordance with para. 7(a) of IFRS 12.
It should be noted that IFRS 10 provides detailed guidance to help the investor make an assessment
of the existence of control. Only the key aspects of this guidance will be discussed.
Power over an investee

Appendix A of IFRS 10 defines power as the current ability to direct the activities that significantly
affect the investee’s returns. Those activities are denoted as ‘relevant activities’ (Appendix A)
and include a range of operating and financial activities such as selling and purchasing
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goods and services, acquiring and disposing of assets, and determining a funding structure
(IFRS 10, para. B11). Relevant activities may change over time and depend on the purpose
and design of the investee.
The ability to direct the relevant activities of an investee arises from existing rights (IFRS 10,
para. 11) and these rights can be:
• voting rights;
• rights to ‘appoint, reassign or remove the investee’s key management personnel’
• contractual rights (IFRS 10, para. B15).
The rights must be substantive in that the investor has the practical ability to exercise the
rights when decisions about relevant activities are being made. A right is not substantive if
there are barriers to exercising the right, such as legal or regulatory requirements (IFRS 10,
paras B22 and B23). Examples of such barriers include restrictive terms and conditions attached
to the rights that make them unlikely to be exercised. Also, rights that are purely protective—
that is, rights that just protect the interest of the holder (e.g. the right of a secured creditor to
take possession of the assets over which the debt is secured if the borrower (investee) fails to
pay back the debt when it falls due)—cannot be considered as giving power over the investee.
Importantly, the investor has to have the current ability to direct the relevant activities for power
to exist (IFRS 10, para. 12), but that does not mean that it has to be exercised; the fact that the
investor does not exercise its current ability to direct the relevant activities of the investee does
not mean that power does not exist.
In many cases, the assessment of power will be straightforward. For example, in most circumstances
the relevant activities of the investee are directed by the board of directors of the investee. If the
investor holds the majority of the voting shares in an investee (more than 50%), the investor will
have the current ability to appoint the directors of the investee, who in turn direct the investee’s
relevant activities (IFRS 10, para. B35). In such cases, the investor has power over the investee.
However, there are other circumstances where the relevant activities of the investee are directed by
the government or a liquidator (IFRS 10, para. B37) and therefore the investor may have the majority
of voting rights but may not have power. For example, when an entity is not able to pay its debts
when they fall due and cannot be saved by an administrator appointed by the court or its creditors,
the entity needs to be placed under the control of a liquidator. In those cases, the directors
relinquish their decision-making powers and so does the investor that had a controlling interest
(i.e. the majority of voting rights) before the liquidation proceedings started.
Just as an investor that holds the majority of the voting shares in an investee may not have
power, there may be cases where an investor that holds less than the majority of the voting
shares is considered to have power when other factors are taken into account. These factors
(IFRS 10, para. B38) could include:
• the investor’s contractual arrangements with other vote holders which give the investor
power (IFRS 10, para. B39). For example, an investor holding 40 per cent of the voting rights
in an investee may have a current contractual agreement with another voting rights holder
that has 15 per cent of the voting rights; if that contractual agreement establishes that the
other vote holder will always vote with the investor in meetings where decisions are made
about relevant activities of the investee, the investor is considered to control the investee
• the investor’s rights from other contractual arrangements (e.g. contractual rights to direct
certain relevant activities) (IFRS 10, para. B40). For example, if an investor has a contractual
right to direct a type of relevant activity, an assessment has to be made about whether the
relevant activity significantly affects the investee’s returns. If so, the investor is deemed to
have control over the investee
• the size of the investor’s voting rights relative to the size and dispersion and apathy of
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other vote holders (IFRS 10, paras B41–5). For example, if an investor holds 40 per cent of
the voting rights in an investee and all the other voting rights holders each hold less than
0.1 per cent and do not normally attend meetings where decisions about relevant activities
are made, the investor may have control
• the investor’s potential voting rights (IFRS 10, paras B47–50). For example, an investor will
have control over an investee if it holds 30 per cent of the voting rights in the investee
and also options that can be exercised currently to increase its percentage of voting rights
above 50 per cent
• a combination of the previous four factors.
Therefore, it is important to consider all the facts and circumstances when assessing the
existence of power, including performing a detailed analysis of voting rights held by other
parties and existing contractual arrangements (IFRS 10, para. 11).
If you wish to explore this topic further you may now read IFRS 10, paras 10–14, B9–18, and B34–50.
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Exposure, or rights, to variable returns from an investee

The second essential criterion for control is that the investor must be exposed, or have rights,
to variable returns from its involvement with the investee. In essence, this requires that the
investor’s returns (either positive or negative) have the potential to vary with the performance
of the investee (IFRS 10, para. 15). Examples of such returns include:
• dividends that will vary with the investee’s profit
• changes in value of investor’s investment
• performance fees or remuneration for managing the investee’s assets
• other returns from the investor and investee combining operating functions such
as economies of scale, cost savings and access to intellectual property (IFRS 10,
paras B56 and B57).
It should be noted that other parties, apart from the investor that has control, can also share
in the returns of the investee (IFRS 10, para. 16). For example, where an investee is only partly
owned by an investor (e.g. the investor holds 60% of the ownership interest that carries voting
rights), both the investor and the holders of the remaining interest (i.e. non-controlling interest
shareholders) share in the returns of the investee. However, in order to have control, the other
attributes of control have to exist (e.g. the party that shares in the returns of the investee must
also have power over the investee arising from substantive rights).
If you wish to explore this topic further you may now read IFRS 10, paras 15–16 and B55–7.
Link between power and variable returns

The final essential criterion for control to exist is that the investor should be able to use its power
to affect the variable returns it receives from its involvement with the investee (IFRS 10, para. 17).
That is, the investor can use its current ability to direct the investee’s relevant activities so that it
receives greater positive returns or limits negative returns.
This link between power and returns is necessary to distinguish an investor that has control over
an investee from an agent with decision-making rights over an investee that is acting on behalf
of an investor (IFRS 10, para. 18). An agent is a party engaged to act on behalf of another party
(i.e. the principal) who will benefit from the agent’s activities. As such, an agent cannot control
an investee (IFRS 10, para. B58). However, if an investor has delegated decision-making rights
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to an agent, the investor must treat these rights as if they were its own rights when determining
whether it has control over an investee (IFRS 10, para. B59). IFRS 10, para. B60 specifies that
the following factors should be considered when a decision-maker determines whether it is a
principal or an agent:
• the scope of its decision-making authority over the investee (e.g. discretion over various
relevant activities)
• rights held by other parties (e.g. do other parties have the right to remove the
decision‑maker?)
• entitlements to remuneration (e.g. the more the remuneration varies with the performance
of the investee, the more likely it is that the decision-maker is a principal)
• exposure of the decision-maker to variability of returns from other interests held in the
investee (i.e. the greater the size and variability of return associated with the interests of
the investor, the more likely it is that the decision-maker is a principal).
If you wish to explore this topic further you may now read IFRS 10, paras 17–18 and B58–72.
Exception to consolidation of subsidiaries—investment entities

In October 2012, the IASB issued amendments to IFRS 10 to exempt a parent that is an investment
entity from consolidating its subsidiaries or applying IFRS 3. Instead of consolidating the subsidiary,
the investment entity needs to measure its investment in the subsidiary at fair value, with changes
in fair value being included in the P&L in accordance with IFRS 9 (IFRS 10, para. 31). The reason for
this exception is that these entities acquire the shares of other entities mainly in order to benefit
from the increase in the value of those shares and are not interested in exercising the control rights
obtained through the investment. These investments are normally held for sale, so it is fitting they
be recognised at fair value as that represents the economic benefit to be extracted from them,
with any increases recognised directly in the P&L.
To determine whether a parent is an investment entity, IFRS 10 provides guidance in the form
of a definition and a discussion of typical characteristics of such entities.
IFRS 10, para. 27 defines an investment entity as an entity that:

• acquires funds from investors for the purpose of providing investment management services
to those investors
• has an objective to invest funds for its investors to solely provide returns from investment
income, capital appreciation, or both
• primarily measures and assesses performance of its investments on a fair value basis.
Typical characteristics of an investment entity include:

• having more than one investment
• having more than one investor
• investors are not related to the investment entity
• ownership interests are in the form of equity or similar interests (IFRS 10, para. 28).
If you wish to explore this topic further you may now read IFRS 10, paras 4B and 27–33.
➤➤Question 5.11
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(a) ‘X Ltd (X) owns 60 per cent of the share capital of Y Ltd (Y). Thus, Y is a subsidiary of X.’
Explain whether you agree with this statement, providing reasons for your answer.
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(b) ‘X has 44 per cent of the voting rights in Y. The other 56 per cent of voting rights in Y are held
by several hundred shareholders who are geographically dispersed. No other shareholder
owns more than 1 per cent of the voting rights in Y. In general, few of the other shareholders
attend annual general meetings. There are no arrangements between shareholders for making
collective decisions.’
Explain whether X is likely to control Y.
(c) Would it make any difference to your answer to (b), if, apart from X, there were only two
other shareholders in Y, each with a 28 per cent shareholding interest?
(d) Provide two examples of where an investor could have the majority of voting rights but
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no power.
Preparation of consolidated financial statements

In essence, a set of consolidated financial statements is prepared to provide information
concerning the combined financial performance, financial position and cash flow of the group
of entities. Consolidated financial statements are prepared by aggregating the financial
statements of each of the entities in the group, subject to a series of adjustments required by
IFRS 10. The reasons behind those adjustments stem from the fact that the consolidated financial
statements should regard the group of entities as a separate economic entity for which the
investment in itself and transactions between internal parts of it should not be considered as
having an impact on its financial performance, financial position and cash flow.
If you wish to explore this topic further you may now read the scope exclusions contained in IFRS 10,
para. 4.
Combining the financial statements of separate entities (through what is known as the
consolidation process) is usually not a simple matter. Numerous issues have to be addressed
before the consolidated financial statements can be prepared. Consideration of these
issues often results in a series of adjustments being carried out in the first two stages of the
consolidation process.
The initial stage involves adjusting the financial statements of individual entities where they
have not been prepared on a common basis. In particular, adjustments at this stage are required
where the individual entities used dissimilar:
• accounting policies, or
• reporting period ending dates.
These adjustments are necessary because the information that is to be aggregated needs to be
comparable to ensure that the end-of-period aggregation is meaningful and not misleading.
As with individual financial statements, the consolidated financial statements reflect income,
expenses and cash flow for a particular accounting period and assets, liabilities and equity as
at the end of a particular accounting period. If the end of the accounting period considered
by a parent is different from that considered by a subsidiary within the group, without an
adjustment to unify reporting dates the carrying amount of assets and liabilities will be measured
at, and income, expenses and cash flows measured over, different points in time, which may
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mislead users. If the individual entities used different accounting policies to account for similar
transactions, similar items may be treated differently (one entity may measure the cost of
inventories using the first-in, first-out formula, while the other entity may use the weighted
average cost formula) and the aggregated amounts will be difficult to interpret.
If you wish to explore this topic further you may now read IFRS 10, paras 19, B87, B92 and B93,
which discuss the adjustments required to the financial statements of entities within the group prior
to consolidation. Note that for the purposes of this module, it will be assumed that subsidiaries have
prepared their financial statements using uniform accounting policies and reporting periods ending
on the same date as the group. Hence, no adjustments will be required for dissimilar accounting
policies or reporting periods ending on different dates.
The second stage combines the financial statements of the individual entities in order to present
the information as it would have been prepared for a single economic entity. After adjusting
for differences in reporting dates and accounting policies, the financial statements of individual
entities must be combined to reflect the financial performance and position of the group
(IFRS 10, para. B86(a)). This is carried out using a consolidation worksheet, which is not only
a means of aggregation but also permits further adjustments to be made. The worksheet
adjustments are necessary to refocus the accounting entity perspective from the individual
entities (the initial data) to the group as a separate entity (the consolidated financial statements).
However, it should be noted that the worksheet is separate from the records of the individual
entities and the financial statements of the individual entities will not be affected by it.
Study guide | 405
The reason for using a separate worksheet is that the individual entities are still separate legal
entities from the other entities within the group and their records should still include the results
of transacting with those other entities.
Adjustments at this stage are required where:

(a) the parent entity holds an equity interest in a subsidiary, recognised in an investment account
in the parent’s financial statement
(b) the subsidiary’s identifiable assets or liabilities were not recorded at fair value at acquisition
date in the subsidiary’s accounts and they still exist as at the beginning of the current period
(c) transactions have taken place between members of the group and the effects are still
recognised in the assets, liabilities, income or expenses of the individual entities during
the current period.
The adjustments required in (a) and (b) above are referred to in this module as the pre-
acquisition entries because they are adjustments affecting items present at acquisition date.
These adjustments will also include an adjustment to the pre-acquisition equity recorded by
the subsidiary (as the fair value adjustments are recognising the true value of the subsidiary’s
net assets at acquisition), out of which the parent share will next be eliminated, together with
the parent investment in the subsidiary. A detailed explanation of the need to eliminate the
pre‑acquisition equity of the subsidiary on consolidation is included next.
It should be noted that before starting to prepare journal entries to record the adjustments
required in (a) and (b), a so-called ‘acquisition analysis’ can be undertaken that mirrors step
(c) and step (d) of the acquisition method (discussed under the subheading ‘The acquisition
method’ in Part A of this module) by calculating/measuring at acquisition date the:
• fair value of the identifiable net assets in the subsidiary
• fair value of consideration transferred
• fair value of the previously held interest by the parent in the subsidiary (if any)
• value of the non-controlling interest in the subsidiary (if any), and, as a result,
• value of goodwill.
Example 5.10 relates to a simple case where the acquisition analysis does not need to address
the calculation of the fair value of the previously held interest or the value of the non‑controlling
interest, as the acquirer acquired its entire ownership interest of 100 per cent of the shares in the
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subsidiary at acquisition date. It is based on data from Case study 5.1. If you wish to explore this
topic further you may now read points 1–3 of Case study 5.1 in Appendix 5.1.
Example 5.10: Acquisition analysis

In Case study 5.1, the consideration transferred is $230 000. This must be compared with the fair
values of the identifiable assets acquired and liabilities assumed to determine whether there is any
goodwill acquired.
Point 2 of Case study 5.1 is the equity section of Subsidiary Ltd (Subsidiary), which will also be
encountered in subsequent examples in this module. The purpose of this information is twofold:
1. It provides the amount of the book value of the net assets (i.e. assets minus liabilities) recorded
by Subsidiary (by definition, this is equal to the amount of equity), which is then adjusted for the
recognition of previously unrecognised identifiable assets and liabilities (net of tax), fair value
adjustments (net of tax) and adjustments for recognised goodwill from previous acquisitions to
calculate the fair value of identifiable net assets and in determining goodwill.
2. It provides the pre-acquisition equity accounts recorded by Subsidiary that must be eliminated
(together with the business combination reserve recorded in the consolidation worksheet to
recognise fair value adjustments other than those posted directly in the subsidiary’s accounts) as
part of the pre-acquisition elimination entry.
In Case study 5.1, the book value of the net assets of Subsidiary, derived from the book value of the
equity, is $180 000. It is assumed that Subsidiary does not have any goodwill previously recorded
(from any previous acquisitions where it acted as an acquirer), meaning that all its net assets are
identifiable. Also, it is assumed that all identifiable assets are recorded by Subsidiary in its own accounts
prior to the acquisition. With these assumptions in place, the book value of equity of $180 000 is
equal to the book value of identifiable net assets. However, this amount includes plant recorded at
acquisition date at its book value ($60 000), not its fair value ($80 000). As discussed in Part A of this
module, the revaluation of the plant by $20 000 in a business combination will give rise to a deferred
tax liability of $6000 ($20 000 × 30%). This is because, from a group’s perspective, the carrying amount
of the plant will be increased by $20 000, but its tax base will remain constant and this results in a
taxable temporary difference of $20 000 and a deferred tax liability of $6000.
Therefore, the fair value of the identifiable assets acquired less the liabilities assumed for Subsidiary
is calculated as follows:
$
Book value of identifiable net assets of Subsidiary 180 000
Add: Increase in plant to fair value 20 000
Less: Deferred tax liability—revaluation of plant (6 000 )
Fair value of identifiable net assets of Subsidiary 194 000
As this example considers that the parent acquired 100 per cent of the shares in Subsidiary in one go,
there is no non-controlling interest or previously held interest. The goodwill is then simply calculated by
comparing the fair value of the consideration transferred ($230 000) with the fair value of the identifiable
net assets of Subsidiary ($194 000). Therefore, the goodwill acquired by the group is $36 000.
Parent with an equity interest in a subsidiary

Where the parent entity has an equity interest representing shares acquired in the subsidiary,
the parent will recognise in its own accounts an investment asset account based on the
consideration transferred for those shares. This asset must be eliminated in full on consolidation,
together with the parent’s share of the subsidiary’s pre-acquisition equity (IFRS 10, para. B86(b)).
The elimination of the investment in the subsidiary recognised as an asset in the parent’s
accounts is necessary because, from the group’s perspective as a separate economic entity,
the group’s assets cannot recognise investments in itself.
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An explanation for the elimination of the parent’s share of the subsidiary’s pre-acquisition equity
comes from the fact that profits and other comprehensive income (recognised in reserves)
from an investment can only be earned after the investment occurs and therefore only the
post‑acquisition changes in the subsidiary’s equity can be included in the consolidated equity.
If the parent owns 100 per cent of the share capital in the subsidiary, the equity of the group at
acquisition date should be equal only to the equity of the parent at acquisition date.
Example 5.11, based on data from Case study 5.1 in Appendix 5.1, demonstrates that in the
absence of non-controlling interest in the subsidiary, the consolidated equity of the group at
the acquisition date should be equal to the equity of the parent.
Study guide | 407
Example 5.11: C
onsolidated equity at acquisition date
when parent has full ownership interest in
the subsidiary
In addition to the data in Case study 5.1, this example assumes that the following information is recorded
in the individual statements of financial position of Parent Ltd (Parent) and Subsidiary Ltd (Subsidiary):
• For Parent: the total assets were recorded as $1 230 000 (that includes the amount for its investment
in Subsidiary, i.e. $230 000) and total liabilities as $400 000, resulting in total equity of $830 000
(i.e. $1 230 000 – $400 000)
• For Subsidiary: the total assets were recorded as $500 000 and total liabilities as $320 000, resulting
in total equity of $180 000 (i.e. $500 000 – $320 000), recognised as issued capital of $100 000 and
retained earnings of $80 000.
If we want to calculate the equity of the group and demonstrate that it is equal to the equity of Parent
only, we first calculate the consolidated assets and consolidated liabilities, with the difference giving
us the consolidated equity.
In terms of consolidated assets, we start by adding together the total assets of Parent plus the total
assets of Subsidiary (i.e. $1 230 000 + $500 000 = $1 730 000). This amount should be adjusted as it
includes the intra-group investment recognised by Parent based on the consideration transferred of
$230 000. This amount should also be adjusted for the fair value adjustment regarding the plant of
Subsidiary undervalued at acquisition date (i.e. by adding $20 000) and for the goodwill on acquisition
(i.e. by adding a further $36 000, the goodwill determined in Example 5.10). Therefore, the consolidated
assets amount is $1 556 000 ($1 730 000 – $230 000 + $20 000 + $36 000 = $1 556 000).
In terms of consolidated liabilities, we start by adding together the total liabilities of Parent plus the
total liabilities of Subsidiary (i.e. $400 000 + $320 000 = $720 000). This amount should be adjusted for
the deferred tax liability (a part of the liabilities of the group) that arise from the revaluation of the plant
on consolidation of $6000 (30% × $20 000). Therefore, the consolidated liabilities amount is $726 000,
and as the equity is the residual of assets after subtracting liabilities, the consolidated equity is equal
to $830 000 ($1 556 000 – $726 000), which is equal to Parent’s equity only.
Remember that consolidation starts by adding together the items of the individual entities within the
group—that applies to the equity accounts as well. As such, the result above suggests that, in essence,
the equity of Subsidiary is added to the equity of Parent; however, it should be eliminated as part of
the consolidation adjustment so that at acquisition date the consolidated equity only recognises the
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equity of Parent.
As stated in the ‘Assumed knowledge’ section of the Introduction to Part B, it is assumed that, from
your undergraduate knowledge, you can prepare a basic pre-acquisition elimination entry. If this is
not the case, please refer to the Learning Task: Pre-acquisition on My Online Learning and review the
concepts involved.
Finally, to ensure that you can prepare a pre-acquisition elimination entry at the acquisition date that
deals with the revaluation of non-current assets and goodwill, please refer to the ‘Assumed knowledge
review’ at the end of this module and attempt Question 1.
Revaluation of assets
When the parent gains control of another entity, the group is deemed to have acquired the net
assets of that entity. Hence, IFRS 3 needs to be applied in the consolidated financial statements.
As a consequence, the identifiable assets and liabilities of the subsidiary should be reflected in
the consolidated financial statements at fair value.
If the identifiable assets and liabilities are not recorded in the subsidiary’s financial statements
at fair value at acquisition date, fair value adjustments can be posted in either the subsidiary’s
accounts or in the consolidation worksheet. For some assets (e.g. non-current assets like
plant and equipment), accounting standards may allow a choice between these two posting
options, but for other assets (e.g. current assets like inventory), there might only be one option
available. For example, if the adjustment involves a write-down of inventory, the provisions of
IAS 2 Inventories will require this to take place in the records of the subsidiary as the inventory
should always be recorded at the lowest of the cost and the net realisable value (IAS 2, para. 9).
However, if an upwards revaluation of inventory is required, this cannot take place in the financial
statements of the subsidiary because IAS 2 will be contravened and therefore will be recognised
instead in the consolidation worksheet. Inventory must ‘be measured at the lower of cost and net
realisable value' (IAS 2, para. 9) in the records of the subsidiary, not at the fair value placed on
the inventory by the parent entity.
Note: As discussed in Part A of this module, measuring an asset or liability in a business

combination at fair value with no equivalent adjustment to its tax base leads to an additional
temporary difference and the recognition of an increase in a deferred tax asset or liability.
This tax effect should be recognised no matter whether fair value adjustments were posted in
the subsidiary’s accounts or in the consolidation worksheet.
Example 5.12: Revaluation of assets

On 1 March 20X3, Holding Ltd (Holding) signed an agreement with the shareholders of
Subsidiary Ltd (Subsidiary) to acquire the entire issued capital (12 000 shares, at $1.00 per share) of that
company. Holding agreed to issue five Holding shares for every two Subsidiary shares. Subsidiary was
to continue to operate its business as a subsidiary of Holding.
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The terms of the agreement were fulfilled on 30 June 20X3, when the share transfer took place.
Immediately prior to settlement, the statements of financial position for the companies involved were
as follows:
Holding Subsidiary
$000 $000
Liabilities 50 25
270 120
Current assets 40 30
Non-current assets 230 90
270 120
At 30 June 20X3, it was determined that the fair values and the tax bases of the net assets of
Subsidiary were:
Fair value Tax base
$000 $000
Liabilities (25 ) (25 )
125 95
Study guide | 409
The non-current assets were revalued to their individual fair values in the accounting records of
Subsidiary at the same date. The current assets were revalued to their individual fair values in the
consolidation worksheet.
At 30 June 20X3, the shares issued by Holding to the shareholders of Subsidiary traded on the securities
exchange at $5.00 per share.
➤➤Question 5.12
Using the data from Example 5.12:
(a) Calculate the fair value of the consideration transferred.
(b) Provide a pro forma journal entry for Holding to account for the acquisition of Subsidiary’s
shares.
Dr Cr
$000 $000
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(c) Provide a pro forma journal entry for Subsidiary for the revaluation of its non-current assets
to fair value and a consolidation journal entry for the revaluation of the current assets of
Subsidiary to fair value.
Dr Cr
$000 $000
(d) Explain whether the group has purchased goodwill and, if so, calculate the amount
of purchased goodwill.
If Holding prepared a consolidation worksheet on 30 June 20X3, after the pro forma journal
entries referred to in Question 5.12(b) and (c) had been processed, it would appear as follows:
Consolidation worksheet 30 June 20X3 ($000)
Elimination
adjustments
Accounts Holding Subsidiary Dr Cr Consolidated
Issued capital 230† 12 12 230
Retained earnings 140 83 83 140
Revaluation surplus 14 ‡
14
Business combination 7 7‡
reserve
Deferred tax liability 6‡ 3‡ 9
Liabilities 50 25 75
420 140 454
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Current assets 40 30 10‡ 80

Investment in 150 150 —
Subsidiary
Non-current assets 230 110 340
Goodwill 34 34
420 140 160 160 454
†
Original issued capital ($80 000) plus shares issued at fair value to the shareholders of Subsidiary
(30 000 @ $5.00 per share = $150 000).
‡
As the non-current assets were revalued in the subsidiary’s accounts, a revaluation surplus and a related
deferred tax liability was recorded in the subsidiary’s financial statements. As the current assets were
revalued in the consolidation worksheet, the current assets still appear as $30 000 in the subsidiary’s
account, but the increase in their value and a related business combination reserve, together with the
associated deferred tax liability, were recorded into the worksheet.
Study guide | 411
The worksheet illustrates that:

• the acquirer, Holding, includes its interest in the acquiree in its own financial statements as an
asset called ‘Investment in Subsidiary’
• the identifiable net assets of the subsidiary are recorded at their individual fair values in the
consolidated column, as a result of the revaluation being posted either in the subsidiary’s
accounts (for non-current assets in this example) or as an adjustment in the consolidation
worksheet (for current assets in this example)
• a deferred tax liability is recognised due to temporary differences arising on the revaluation
of the net assets of the subsidiary
• on acquisition of the subsidiary, goodwill has been treated as a consolidated adjustment as
it is the group that has acquired the business of the subsidiary
• the ‘Investment in Subsidiary’ account is eliminated, together with the elimination of the
shareholder’s equity of the subsidiary at acquisition date (that includes the revaluation surplus
and the business combination reserve recognised on revaluation of the identifiable net assets
of the subsidiary) and the recognition of goodwill.
Note: The examples in the remainder of this topic will assume that all revaluations of subsidiary
assets where their carrying amounts were different from their fair value at acquisition date are
posted in the consolidation worksheet and not in the subsidiary’s accounts.
➤➤Question 5.13
Using the information in Case study 5.1 and Example 5.10, prepare a consolidation worksheet
adjusting entry as at the acquisition date to record the elimination of the investment account and
of the pre-acquisition equity of the subsidiary. Explain the rationale for your entries.
Depreciation adjustments related to revaluation

of depreciable assets
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When, in accordance with IFRS 3, a depreciable non-current asset has to be revalued to fair
value at the acquisition date in the consolidation worksheet, further consolidation adjustments
will have to be undertaken in subsequent reporting periods to adjust the depreciation charges.
The subsidiary’s depreciation expense will be based on the amount of the asset recorded in its
financial statements. However, the group will want to recognise a consolidation depreciation
expense based on the fair value of the non-current asset recorded in the consolidated financial
statements (IFRS 10, para. B88) and therefore an adjustment to depreciation expense will
be needed. As this adjustment will impact total expenses recognised by the group and,
therefore, consolidated profit, a tax effect adjustment will also need to be posted.
The adjustments to depreciation expense and the related tax effect need to take into account
the current period adjustments and the previous period adjustments that will be recorded
against retained earnings. In addition, the gain or loss recorded in the financial statements of
the subsidiary, when the asset is disposed of, should be adjusted, on consolidation, to reflect
the gain or loss to the group (again, a tax effect adjustment will have to be prepared).
Example 5.13 relates to the pre-acquisition entries in the case of an acquisition that involved
revaluation of depreciable assets and depreciation adjustments after the acquisition date.
It is based on data from Case study 5.1. If you wish to explore this topic further you may now
read point 4 of Case study 5.1, which relates to the depreciation of the plant. Think about the
depreciation expense that would be recorded in the financial statements in Subsidiary and
the depreciation expense that should be recorded by the group.
Example 5.13: D
epreciation adjustments related to
revaluation of depreciable assets
Consider the data from Case study 5.1. As discussed in the answer to Question 5.13, based also on
Case study 5.1, the pre-acquisition elimination entry at acquisition date has resulted in the plant of
Subsidiary Ltd (Subsidiary) being measured at fair value in the consolidated financial statements.
Subsequent consolidation adjustments in the next periods will have to take into account the fact that
the amount of depreciation recorded by Subsidiary will differ from the depreciation that will have to
be recorded by the group.
Subsidiary estimates the remaining useful life of the plant to be five years, with a zero scrap value at the
end of this time. The group will have the same estimate of useful life and residual value as Subsidiary.
Like Subsidiary, the group will also use the straight-line depreciation method for this type of plant,
as the manner in which Subsidiary uses up the service potential of the asset also reflects the way the
group is using it up. Therefore, the depreciation expense for the plant in the financial statements
of Subsidiary is $12 000 per year ($60 000 / 5 years), while in the consolidated statement of profit or
loss and other comprehensive income (P&L and OCI) of the group the required depreciation expense
is $16 000 ($80 000 / 5 years). As a result, the consolidation adjustment after the acquisition date will
have to allow for this increase in depreciation expense every year.
In the statement of financial position of Subsidiary prepared at 30 June 20X1 (i.e. one year after the
acquisition date), the plant is recorded at historical cost to that entity ($100 000) less related accumulated
depreciation ($52 000 = $40 000 + $12 000). This information is entered into the consolidation worksheet
used to prepare the financial statements of the group. A consolidation adjustment is required so
that the consolidated financial statements reflect the cost of the plant to the group ($80 000) and
the related accumulated depreciation for the group ($16 000—it does not include the accumulated
depreciation recorded prior to the acquisition as it was considered to be written off when revalued
at acquisition date).
Therefore, the consolidation worksheet entries for 30 June 20X1 would be as follows:
1. Revaluation of plant to fair value (same as the entry at acquisition date):
Dr Cr
$ $
Plant 20 000
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Business combination reserve 14 000
At the acquisition date (1 July 20X0):

• the financial statements of Subsidiary recorded plant at cost of $100 000, less accumulated
depreciation of $40 000. See point 3 of Case study 5.1.
• Parent Ltd (Parent) considered that the plant owned by Subsidiary had a fair value of $80 000.
In accordance with IFRS 3, the plant must be initially measured at $80 000 (i.e. fair value) in the
consolidated financial statements. See point 3 of Case study 5.1.
Therefore, the consolidation worksheet entry (consolidation adjustment) prepared at acquisition

date must decrease the gross carrying value of the plant by $20 000 (i.e. from $100 000 down
to $80 000) and decrease accumulated depreciation by $40 000 (i.e. from $40 000 down to $nil).
This is reflected in the consolidation worksheet entry (consolidated adjustment) as a debit to
accumulated depreciation of $40 000 and a credit to the gross carrying value of plant of $20 000.
As this entry posted at acquisition date does not carry over to other periods, given it does not
affect the individual statement of the subsidiary, it needs to be repeated at 30 June 20X1 to make
sure the asset value is adjusted to fair value in the consolidated statements. However, a further
adjustment is needed for the year since acquisition date to the depreciation expense recognised
by the subsidiary.
Study guide | 413
2. Depreciation entry and associated tax effect:
Dr Cr
$ $

The adjustment to the depreciation expense for the current year ended 30 June 20X1 ensures
that:
• the depreciation expense is recorded in the consolidated financial statements as $16 000,
being the amount of $12 000 recognised by the subsidiary plus the debit adjustment now
posted against depreciation expense of $4000
• the accumulated depreciation is also recorded from the group’s perspective as $16 000, being
the amount of $52 000 recognised by the subsidiary minus the debit adjustment of $40 000
from the first entry above recognising the revaluation of plant to fair value plus the credit
adjustment now posted against accumulated depreciation of $4000.
The increase of $4000 in depreciation reduces the group’s profit before tax. Hence, the income
tax expense of the group has to be reduced by $1200 ($4000 × 30%). The deferred tax liability of
the group is reduced by $1200, from $6000, recognised in the first entry above for the revaluation
of the plant to $4800, as the taxable temporary difference relating to the plant at 30 June 20X1
is now $16 000. That is, the carrying amount of the plant for the group at 30 June 20X1 is $64 000
(cost of $80 000 less accumulated depreciation of $16 000), while, if it is assumed that the tax
depreciation is equal to the accounting depreciation for this plant, its tax base is $48 000 (the future
deductible amount via Subsidiary). As the asset is used in the business, the additional future
taxable economic benefits recognised on revaluation (i.e. $20 000) remaining are decreased (by
1 divided by the asset’s useful life, i.e. 1/5 of $20 000 = $4000) and, with that, so are the related
future tax effects (i.e. $4000 × 30%).
3. Pre-acquisition elimination entry:

Dr Cr
$ $
Retained earnings (opening balance) 80 000
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Goodwill 36 000
Investment in Subsidiary 230 000
The entry above eliminates the investment by the parent in the subsidiary and the pre-acquisition
equity of the subsidiary at acquisition date (that includes the business combination reserve
recognised on revaluation of plant) and recognises the goodwill on acquisition. Even though
this is the entry that would be prepared at acquisition date, it is repeated unchanged at
30 June 20X1 because:
• the entry prepared at acquisition date does not carry over
• there are no movements that affect the accounts originally included in the entry.
A consolidation worksheet would reveal, in part, the following:
Elimination
adjustments
Parent Subsidiary Dr Cr Consolidated
Account $000 $000 $000 $000 $000
Depreciation expense 12 4 16
Plant 100 20 80
Less: Accumulated depreciation (52) 36 (16)
48 64

➤➤Question 5.14
(a) Using points 3 and 4 of Case study 5.1 and the information from Example 5.10, prepare
a consolidation worksheet adjusting entry for the year ended 30 June 20X2. Explain the
rationale for account(s) that differ(s) from the 30 June 20X1 entry discussed previously.
(b) Refer to point 5 of Case study 5.1, which relates to the sale of the plant. Prepare a consolidation
adjusting entry for the year ending 30 June 20X3. Explain the rationale for accounts debited
and credited that differ from (a).
(c) Provide the consolidation adjusting entry that would be necessary in years subsequent to
the year ended 30 June 20X3. Explain the rationale for accounts debited and credited that
differ from (b).
Please refer to the Learning Task: Pre-acquisition elimination on My Online Learning for further
practice on pre-acquisition elimination.
Transactions within the group

The content of consolidated financial statements is determined by focusing on the group as a
single economic entity. IFRS 10, para. B86(c) reinforces the financial accounting concept that
requires that before preparing consolidated financial statements, the scope or boundary of the
entity for which they are prepared (i.e. the group) must first be determined. Such denotations
limit the content of the resulting financial reports to reflect only transactions involving the group
and parties external to it. Internal events are ignored.
From the individual entity’s point of view, a transaction involving another member of the
group is an external event to be reported in the financial statements of that entity. From the
perspective of the group, the same transaction is an ‘internal’ one and should be eliminated
from the consolidated financial statements. An intra-group transaction is, from the perspective
of the group, a similar transaction as a transaction between two departments of a single entity.
Figure 5.7 illustrates these important consolidation concepts.
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Figure 5.7: Transactions within the group

Group
External Internal External

transaction— transactions transaction—
included in —eliminate included in
group financial group financial
statements statements
Parent Subsidiary

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Therefore, as part of the consolidation process, after the initial adjustments are made in the
pre-acquisition entries discussed previously, the group must eliminate in full all the effects
of intra-group transactions. That may involve adjusting the amounts recognised for assets,
liabilities, income and expenses to reflect only the impact of transactions with external parties.
Eliminating the effects of intra-group (internal) transactions is achieved via adjusting entries
in the consolidation worksheet. In essence, this worksheet adjustment reverses the effect
of the original entries processed by the individual entities involved in those transactions so
that the consolidated financial statements reflect only transactions between the group and
parties external to the group.
It should be noted that the effects of a transaction ‘within the group’ may carry forward in the
individual statements of the parties involved to future periods that come after the period when
the original intra-group transaction took place. Therefore, an intra-group transaction from a
period may not only require adjusting entries in the consolidation worksheet prepared at the
end of that period, but also in the subsequent accounting periods, to eliminate any account
balances still affected. That is because the worksheet adjustment from one period does not
carry over to the next, as at the end of each period, the consolidation process starts with adding
together the financial statements of the group entities that are not affected by prior periods’
consolidation adjustments. For example, if an intra-group loan from a previous period is still
unpaid at the end of the current period, the balance of the loan still needs to be eliminated
on consolidation from the loan receivable and loan payable.
However, the general accounting requirement that income and expense accounts are closed to
retained earnings at the end of the period may help eliminate the need for further consolidation
adjustments related to some intra-group transactions. For example, the interest expense
and interest revenue on an intra-group loan for the current period will need to be eliminated
on consolidation, but the interest expense and interest revenue from previous periods will not.
This is because they are already eliminated by aggregating the retained earnings accounts of
the entities that recognised a decrease and an increase in retained earnings respectively for the
interest expense and interest revenue on the loan, which were closed to retained earnings at
the end of the previous periods.
Realisation of profit or loss by group
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Some intra-group transactions, such as the sale of inventory or non-current assets, may involve
eliminating profits or losses recorded by the parent or subsidiary. That is because those profits or
losses are unrealised from the group’s perspective. Those profits or losses would be recognised
as realised by the group when the assets involving the intra-group profits or losses were either
sold to a party external to the group or when the group consumed a part of the future economic
benefits of the assets and recognised that via depreciation or amortisation. Therefore, profit from
some intra-group transactions will be recognised in the financial statements of the individual
entities within the group in reporting periods that may differ from when that profit is eventually
recognised in the consolidated financial statements.
The central focus of this recognition test is the direct, or indirect, involvement of a party
external to the group. In relation to inventory, a direct involvement occurs when the inventory
is subsequently sold to that external party. For example, if some inventory was sold intra-group
for $20 000, while the original cost paid to an external supplier was $15 000, to the extent that
this inventory is still with the group, the profit of $5000 is considered unrealised from the group’s
perspective. However, once the inventory is sold to external parties, let’s say for $22 000, the group
should recognise a profit of $7000 (i.e. $22 000 – the original cost of $15 000), which can be seen to
comprise the unrealised intra-group profit of $5000 plus an additional $2000 recognised when the
intra-group buyer sells the inventory to external parties (i.e. $22 000 – $20 000). As such, the profit
on the intra group profit is now realised from the group’s perceptive.
With depreciable assets transferred within the group, external parties are involved indirectly when
the goods or services produced by the asset are sold outside the group. As the depreciation is
supposed to reflect the use of the depreciable assets to produce goods or services that will be
sold to external parties, it is said that the unrealised profit of intra-group transfers of depreciable
assets is realised through depreciation. In essence, as the depreciated part of the asset cannot
be used in the business any more, it is equivalent to having been sold to external parties and
therefore the part of the intra-group profit proportional to how much of the asset was depreciated
since it was sold intra-group is now considered to be realised.
For example, if a depreciable non-current asset purchased from an external entity for $100 000
is sold immediately intra-group for $130 000, the intra-group profit of $30 000 is considered
unrealised from the group’s perspective. However, assuming that the useful life of the asset is
five years, with economic benefits from the asset to be consumed evenly, at the end of one full
year after the intra-group sale, one-fifth of the asset’s economic benefits have been consumed.
As such, profit of $6000 ($30 000 / 5 years) each year can be considered realised and recognised
in the group’s accounts. Note that the group does not recognise this as directly affecting profit;
rather, the depreciation expense recognised by the intra-group buyer of $26 000 ($130 000 /
5 years), being overstated from the point of view of the group (which will only recognise $20 000,
based on the original cost of $100 000 / 5 years), will be adjusted on consolidation, resulting in
a decrease in depreciation expense by $6000 that will indirectly affect the profit, increasing it by
$6000 ($26 000 – $20 000) each year.
Not all intra-group transactions generate unrealised profits from the group’s perspective.
Intra‑group transactions that result in an equal and offsetting amount recognised in the current
period under revenue and expense items do not have a net impact on the profit or loss obtained.
As such, there is no unrealised profit that needs to be eliminated on consolidation, but that does
not mean that there won’t be any eliminations required. The individual expense and revenue
accounts will still need to be adjusted to eliminate the intra-group amounts.
For example, when management services are provided within the group for $40 000, the provider
entity recognises revenue of $40 000, while the entity receiving the services records an expense
for the same amount. If the provider and receiving entity recognise profits for the whole period
of $100 000 and $80 000 respectively, inclusive of those intra-group revenues and expenses,
the aggregated amount for profit will be $180 000. To eliminate the effects of the intra-group
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transaction, the adjusted profits of the entities would be $60 000 (i.e. $100 000 – $40 000)
and $120 000 ($80 000 + $40 000) and aggregating those amounts would give us the same
result as before. As such, it is said that the aggregated profit of $180 000 does not include
unrealised profits. Nevertheless, adjustments will still be required in the current period to
make sure that the revenues and expenses are not overstated from the group’s perspective.
Other transactions in this category include intra group dividends and interest.
Table 5.4 summarises the accounting treatment of intra-group transactions.

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Table 5.4: Accounting treatment of intra-group transactions
Unrealised profit
Original transaction (recognised by legal entity) Profit recognised by group
Intra-group sale Eliminate unrealised intra-group profit If held as inventory by the purchaser
of inventory or loss in the period of sale and any within the group—recognise profit or
remaining unrealised profit in later loss when the inventory is sold to party
reporting periods while the inventory external to group.
remains in the group.
If held as depreciable asset by
the purchaser within the group—
recognise profit or loss consistent with
the depreciation allocation of asset.
Intra-group sale of Eliminate unrealised intra-group If used as depreciable asset by

depreciable asset profit or loss in the period of sale and the purchaser within the group—
any remaining unrealised profit in recognise profit or loss consistent with
subsequent reporting periods while the depreciation allocation of asset.
the asset remains in the group.
If the depreciable asset becomes
inventory for the purchaser within the
group—recognise profit or loss when
the inventory is sold to party external
to group.
Intra-group provision No unrealised profit. Eliminate Not applicable.

of services relevant income and expense items.
Payment of dividend Eliminate dividend income and Not applicable.

by subsidiary retained earnings appropriation.
Intra-group interest No unrealised profit. Eliminate Not applicable.

relevant income and expense items.
However, the examples in Table 5.4 are conventions that help explain the shortcuts that can
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be applied in preparing the adjusting entries for intra-group transactions. It is important to
note that unrealised profits arise only from intra-group sales of assets for a profit. After such an
intra‑group transaction, the amount recognised by the entity holding the assets within the group
is overstated from the group’s perspective. That is because when an asset is sold within the
group for a profit, it will be recorded in the financial statements of the individual entity holding
the asset at an amount that differs from the amount that should be recorded in the consolidated
financial statements, being the original cost to the group, adjusted for depreciation (if applicable)
based on that cost. The difference will be equal to the unrealised profit. When eliminating an
unrealised profit, it is important to make sure that the value of the asset incorporating that profit
is adjusted for the unrealised amount.
This module assumes you can prepare consolidation elimination entries that deal with intra-group
transactions excluding tax effects. If this is not the case, refer to the Learning Task: Intra-group
transactions, and review the concepts involved.
To test your understanding of intra-group transactions consolidation elimination entries, you may
attempt Question 2 of the ‘Assumed knowledge review’ at the end of the module. If you wish to
explore this topic further you may now read IFRS 10, para. B86(c).
Tax effects of intra-group transactions

One consideration when eliminating transactions within the group is whether there are any
tax effects to be accounted for in accordance with IAS 12 (discussed in Module 4). Profit from
some intra-group transactions will be recognised in the financial statements of the individual
entities within the group in reporting periods that may differ from when that profit is eventually
recognised in the consolidated financial statements. This suggests the need for tax adjustments
from the group’s perspective. If a profit is recognised in a period by an individual entity and
not by the group, that results in an income tax expense recognised by the individual entity that
should be eliminated on consolidation. Also, in that case, as the individual entity pays the tax on
this profit, that represents a prepayment of tax from the group’s perspective. Therefore, when the
profit will eventually be realised in the future by the group, the tax will not have to be paid again.
That is equivalent to having a tax benefit deferred for the future until the profit becomes realised.
The deferred tax benefit will be recognised by the group as a deferred tax asset when eliminating
the income tax expense on the unrealised profit.
For example, if inventory is sold intra-group at a profit of $20 000, the seller will recognise that
profit in its individual records and it will pay tax of $6000 on it (assuming the tax rate of 30%).
However, as long as the entire inventory is still on hand with the intra-group buyer, from the
group’s perspective, the tax should not have been paid yet and should be recognised as a
prepayment of tax that will bring tax benefits in the future. Therefore:
• the income tax expense recognised by the intra-group seller will be eliminated on
consolidation as it was not yet incurred from the group’s perspective
• a deferred tax asset will be recognised to show that when the profit will be realised from
the group’s perspective, the tax on it will not have to be paid again. That is, a deductible
temporary difference originates when the intra-group seller pays tax, which subsequently
reverses when the group realises profit on the sale of inventory.
If you wish to explore this topic further you may now read IFRS 10, para. B86(c).
Example 5.14 relates to Case study 5.2. Example 5.14 demonstrates the application of the
principles of accounting for intra-group transactions in the context of the sale of inventory within
the group. These principles include the need to:
• eliminate intra-group profits or losses until realised via the involvement of a party external
to the group
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• measure the asset transferred within the group at the cost to the group
• account for deferred tax assets or deferred tax liabilities arising from measuring assets
transferred within the group at the cost to the group.
Example 5.14: Intra-group transactions—sale of inventory

In Case study 5.2, the parent entity sold inventory to a subsidiary for $40 000 on 1 June 20X3. The cost
of the inventory to the parent was $30 000.
As previously discussed, for a proper understanding of the consolidation adjustment necessary to

eliminate the effects of the intra-group transaction, it is important to understand what the effects
really are. To achieve this, first consider the entries that were posted in the individual financial records
of the parent entity and the subsidiary as a result of this transaction:
Entry processed by the parent (1 June 20X3):

Dr Cr
$ $
Bank 40 000
Cost of goods sold 30 000
Sales 40 000
Inventory 30 000
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Entry processed by the subsidiary (1 June 20X3):

Dr Cr
$ $
Inventory 40 000
Bank 40 000
The entry processed by the parent records both the sale of inventory at the selling price
(Dr Bank $40 000 and Cr Sales $40 000) and the outflow of inventory at the cost price (Dr Cost of
goods sold $30 000 and Cr Inventory $30 000). The entry processed by the subsidiary records the
cash purchase of inventory from the parent at the price charged by the parent (Dr Inventory $40 000
and Cr Bank $40 000). From a group perspective, starting with the Bank account, given that a credit
and a debit was recognised in the individual accounts for the same amount, the net effect is nil and
therefore there is no need for adjustment. Next, the cost of goods sold and sales revenue need to be
eliminated in full, which results in an overall decrease in profit of $10 000 (the elimination of cost of
goods sold decreases the expenses, which increases the profit by $30 000, but the elimination of sales
revenue decreases the profit by $40 000). The decrease in profit has tax effects that will be recognised by
decreasing the income tax expense and recognising a deferred tax asset for the deductible temporary
difference arising from the tax paid by the parent on the unrealised intra-group profit. With regards
to the inventory account, the parent recognises that it transferred the items to the subsidiary, so that
inventory will disappear from its accounts and appear in the subsidiary accounts, but the amount
recognised is $40 000 (the price paid intra-group). However, if this transaction did not take place from
the group’s perspective, that means that the inventory should still be recorded at the original cost of
$30 000. As such, the inventory is overstated (by $10 000, being the unrealised profit) and should be
adjusted. These adjustments can be visualised in the consolidation worksheet below, which includes
only the affected accounts (a tax rate of 30% is used).
Consolidation worksheet (1 June 20X3)

Elimination
adjustments
Account $ $ $ $ $
Sales 40 000 40 000 —
Less: Cost of goods sold (30 000) 30 000 —
Gross profit 10 000 —
Profit before tax 10 000 —
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Income tax expense (3 000) 3 000 —
Profit for the year 7 000 —

Inventory 40 000 10 000 30 000
Deferred tax asset 3 000 3 000
Notes
• The consolidated P&L and OCI does not include the sales revenue and cost of goods sold that
did not result from a transaction with parties external to the group.
• Inventory is measured in the consolidated statement of financial position at the original cost to
the group, and not at the cost to the subsidiary, which is based on the price paid intra-group and
includes the profit recognised by the parent from the sale within the group.
• As the profit on the sale is not recognised by the group, this requires the income tax expense of
the group to be reduced (a credit of $3000: 30% of the unrealised profit of $10 000).
• The group has recognised a ‘deferred tax asset’ because the tax expense on the unrealised profit
is a prepaid tax that will give rise to a tax benefit in the future when the profit will be realised from
the point of view of the group.
In Case study 5.2, the inventory was still on hand at the end of the financial year 30 June 20X3, so there
are no other transactions that may be impacted by this original intra-group transaction. Note that if
the inventory was sold to an external party, the entries processed by the subsidiary to recognise the
external sale would consider the cost of goods sold based on the price paid intra-group, so cost of
goods sold would also be affected by the intra-group sale and therefore would need to be adjusted.
If, for example, 50 per cent of the inventory was sold by the subsidiary to an external party for $24 000
by 30 June 20X3, the subsidiary would record the following additional entry:
Dr Cr
$ $
Bank 24 000
Sales 24 000
Inventory 20 000
However, from the group’s perspective, the cost of goods sold should only recognise the cost
of the inventory sold to external parties based on the original cost of that inventory prior to
the intra‑group transfer (i.e. 50% of $30 000 = $15 000). As the Bank and Sales accounts recognise the
price received from an external party, they do not need to be adjusted. Therefore, the adjustment
on consolidation will initially just need to reverse the debit to cost of goods sold and the credit to
inventory by $5000 ($20 000 – $15 000). However, as that adjustment will increase the profit before tax
(and knowing that the intra-group profit has been realised in proportion of 50%), a tax effect adjustment
entry will also need to be posted on consolidation to reverse the tax effect for the realised profit.
In particular, the tax effect adjustment entry records the partial reversal of the deductible temporary
difference that arose from the intra-group sale, as profit has now been realised from the sale of
inventory to an external party. These adjustments can be visualised in the consolidation worksheet
below, which includes only the affected accounts (a tax rate of 30% is used).
Eliminations
adjustments
$ $ $ $ $
Sales 40 000 24 000 40 000 24 000
Less: Cost of goods sold (30 000) (20 000) 30 000
5 000 (15 000)
Gross profit 10 000 4 000 9 000
Profit before tax 10 000 4 000 9 000

Income tax expense (3 000) (1 200) 1 500 3 000 (2 700)
Profit for the year 7 000 2 800 6 300
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Inventory 20 000 5 000 10 000 15 000
Deferred tax asset 3 000 1 500 1 500
Notes
• The consolidated P&L and OCI includes only the sales revenue from the external sale ($24 000)
and cost of goods sold to external parties based on the original cost of that inventory to the
group (50% of $30 000).
• Inventory remaining is measured in the consolidated statement of financial position at the original
cost to the group (50% of $30 000), and not at the cost to the subsidiary, which is based on the
price paid intra-group and includes the profit recognised by the parent from the sale within
the group and not yet realised.
• As the profit is recognised by the group as $9000, this requires the income tax expense of the
group to be $2700.
• The group has recognised a ‘deferred tax asset’ because the tax expense on the unrealised profit
is a prepaid tax that will give rise to a tax benefit in the future when the profit will be realised from
the point of view of the group (50% of the original deferred tax asset of $3000).

Study guide | 421
➤➤Question 5.15
(a) Refer to Case study 5.2 and use assumption 1. Prepare pro forma consolidation worksheet
entries for the year ended 30 June 20X4. Explain the rationale for your entries.
(b) Refer to Case study 5.2 and use assumption 2. Prepare pro forma consolidation worksheet
entries for the year ended 30 June 20X4. Explain the rationale for your entries.
(c) Assume that on 1 July 20X2, a subsidiary sold to its parent entity an item of plant for
$50 000. The plant had cost the subsidiary $100 000 and had a carrying amount of $40 000.
While the subsidiary had depreciated the plant using the reducing-balance method at a rate
of 30 per cent, the parent entity is depreciating the plant on a straight-line basis over five
years with a zero scrap value at the end of its useful life.
Prepare pro forma consolidation worksheet entries for the financial years ending 30 June
20X3 and 30 June 20X4 to account for this transaction from the group’s point of view. Assume
a tax rate of 30 per cent and explain the rationale for your pro forma entries. (Hint: First
think about the entries that would be processed in the accounting records of the parent and
subsidiary as a result of the transaction.)
Now that the discussion of intra-group transactions is completed, please refer to the Learning Task:
Intra-group transactions on My Online Learning for further practice.
Non-controlling interest
So far, the discussion has focused primarily on the preparation of consolidated financial
statements for parent entities that have 100 per cent ownership interest in a subsidiary.
Another situation is when a parent entity owns less than the total issued capital of a subsidiary.
In this situation, a ‘non-controlling interest’ exists that should be recognised in the consolidated
For example, a non-controlling interest would exist where the parent entity owned 70 per cent
of the issued capital of a subsidiary. The equity participants (i.e. the shareholders or owners)
in the parent entity have an interest in the group through their direct interest in the parent and
an indirect interest (via the investment) in the subsidiary. The holders of the other 30 per cent
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of the issued capital of the subsidiary have an interest in the group through their investment in
the subsidiary. This is illustrated in Figure 5.8.
Figure 5.8: Non-controlling interest

Parent entity Non-controlling
owners interest
100% GROUP 30%
Parent entity 70% Subsidiary
Although not explicitly stated, IFRS 10 uses the ‘entity concept’ (also referred to as ‘economic
entity concept’) of consolidation and as a consequence, a non-controlling interest is classified
as part of consolidated equity. This module does not discuss the alternative concepts of
consolidation. However, you should appreciate that there are several ways to measure and
classify non-controlling interests.
The important features of the entity concept of consolidation are as follows:

• all assets, liabilities, income and expenses of a similar nature in the financial statements of
entities within the group are combined, subject to any required consolidation adjustments
• the effects of transactions within the group are eliminated in full
• the non-controlling interest is classified as an equity participant in the group
• the non-controlling interest is entitled to the respective proportionate interest in the equity
of the subsidiary after making adjustments for unrealised profits and losses of the subsidiary
arising from intra-group transactions.
The first two features listed have already been discussed in this module. Using the entity concept
of consolidation, the existence of a non-controlling interest requires three modifications to the
consolidation process. These affect:
1. the pre-acquisition elimination entry
2. the treatment of dividends paid by the subsidiary
3. the measurement and disclosure of the non-controlling interest in the consolidated
financial statements.
1. Pre-acquisition elimination entry

Where the parent entity acquires less than a 100 per cent interest in the subsidiary, the consolidation
pre-acquisition elimination entry should eliminate the carrying amount of the parent’s investment in
the subsidiary and the parent’s portion of equity in the subsidiary at the acquisition date (IFRS 10,
para. B86(b)). The elimination of the investment in the subsidiary recognised as an asset in the
parent’s accounts is necessary because, from the group’s perspective as a separate economic
entity, the group’s assets cannot recognise investments in itself. The reason for the elimination
of the parent’s share of the subsidiary’s equity was discussed under the subheading ‘Parent with
an equity interest in a subsidiary’ above.
The pre-acquisition equity balances of the subsidiary not eliminated on consolidation represent
the non-controlling interest in the fair value of the net assets of the subsidiary at the acquisition
date and form part of its equity in the group.
Example 5.15 illustrates the pre-acquisition elimination entry where the parent entity acquires less
than a 100 per cent interest in the subsidiary. The purpose of this example is to demonstrate the
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key consolidation principle that the parent entity’s share of equity of the subsidiary at acquisition
date must be eliminated as part of the pre-acquisition elimination entry. This principle is applied
both at acquisition date and in subsequent reporting periods. The amount of pre-acquisition
equity of the subsidiary remaining after this elimination entry is the non-controlling interest’s
share of the equity of the group at acquisition date (ignoring intra-group transactions—to be
discussed shortly).
If you wish to explore this topic further you may now read IFRS 10, para. B86(b).
Example 5.15: N
on-controlling interest—consolidation
pre‑acquisition elimination entry
On 1 July 20X2, Parent Ltd (Parent) purchased 70 per cent of the shares of Subsidiary Ltd (Subsidiary)
for $160 000. At the acquisition date, the equity section of Subsidiary contained the following accounts:
$
200 000
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Assuming that all the assets and liabilities of Subsidiary recognised prior to the acquisition are
identifiable and are recorded at fair value, the goodwill on consolidation would be calculated as follows:
$
Consideration transferred 160 000
Non-controlling interest (30% of $200 000) 60 000
220 000
Less: Fair value of identifiable net assets (200 000 )
Goodwill 20 000
The non-controlling interest in the group at the acquisition date is measured as its share of the fair
value of the identifiable net assets of Subsidiary. Hence, the non-controlling interest equals 30 per cent
of $200 000, or $60 000.
The following worksheet illustrates the pre-acquisition entry required and the allocation of consolidated
equity between the non-controlling interest and parent equity interest. For the purpose of the worksheet
it has been assumed that, at the acquisition date, the equity of Parent was:
$
500 000
Elimination Non- Parent

adjustments controlling equity
Parent Subsidiary Dr Cr Consolidated interest interest
Account $000 $000 $000 $000 $000 $000 $000
Issued capital 300 100 70 330 30 300
500 200 560 60 500
Other net assets 340 200 540

Investment in 160 160 —
Subsidiary
Goodwill 20 20
500 200 160 160 560
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Notes
• The pre-acquisition entry eliminates the investment account recognised by the parent and the
parent entity’s share of pre-acquisition equity in the subsidiary at the acquisition date, as well as
recognising goodwill on consolidation.
• The amount of the net assets of the group is $560 000, which includes the goodwill of $20 000.
• There are two groups of shareholders who have an interest in the group: the parent shareholders
and the non-controlling interest. At the acquisition date, the parent shareholders’ interest in the
consolidated net assets is the equity of Parent, $500 000. The non-controlling interest’s share of the
consolidated net assets is reflected in its 30 per cent interest in the equity of Subsidiary—that is,
30 per cent of $200 000 or $60 000. This amount reflects its share of the fair value of the net assets
of Subsidiary. Remember, Parent’s share of the equity of Subsidiary at the acquisition date has
been eliminated on consolidation.

➤➤Question 5.16
To extend Example 5.15, assume that:
• during the 20X3 financial year, Parent and Subsidiary recorded profits of $100 000 and
$50 000 respectively
• neither company paid, or declared, a dividend during the 20X3 financial year—the increase
in each company’s retained earnings during this year is equal to its 20X3 profit.
Complete the following consolidation worksheet.

Account $000 $000 $000 $000 $000 $000 $000
600 250
Other net assets 440 250
Investment in 160
Subsidiary
Goodwill
600 250
Example 5.15 accounted for the business combination at the acquisition date by applying the
acquisition method in accordance with IFRS 3. That is:
• the identifiable net assets of the subsidiary were measured at their acquisition date fair values
(IFRS 3, para. 18)
• the non-controlling interest was measured at its proportionate share of the fair value of the
subsidiary’s identifiable net assets at the acquisition date (IFRS 3, para. 19)
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• goodwill was measured at the acquisition date as the difference between the fair value of the
consideration transferred by the parent plus the non-controlling interest in the subsidiary less
the fair value of the identifiable net assets of the subsidiary (IFRS 3, para. 32).
In Example 5.15, the net assets of the subsidiary were measured at fair value on the acquisition
date. Where the net assets of the subsidiary are not measured at fair value at acquisition date,
consolidation adjustment entries are required to achieve this. After accounting for any tax effects
by recognising a deferred tax liability, the after-tax consolidation revaluation is recognised in a
business combination reserve.
In earlier examples, the pre-acquisition entry eliminated the business combination reserve
in full, as the parent owned 100 per cent of the equity of the subsidiary. Where there is a
non‑controlling interest, the pre-acquisition entry eliminates the parent’s share of the business
combination reserve. The remainder of the reserve is included in the non-controlling interest’s
share of the consolidated equity. That is, at the acquisition date, the non-controlling interest is
equal to its share of the subsidiary’s recorded equity plus its share of the business combination
reserve. This is equal to the non-controlling interest in the fair value of the identifiable net
assets of the subsidiary at the date of the acquisition (IFRS 3, para. 19).
If you wish to explore this topic further you may now read IFRS 3, paras 18 and 32. For the purposes
of this module, assume that where a non-controlling interest is involved, the net assets of the
subsidiary are measured at their fair values at the acquisition date.
Study guide | 425
2. Dividends paid by subsidiary

This consolidation adjustment entry will only eliminate the dividend paid/payable within the group
(i.e. by the subsidiary to the parent), as only that represents intra-group dividends. The proportion
of dividend paid/payable by the subsidiary to the non-controlling interest shareholders will not
be eliminated because a party external to the group is involved. Elimination entries 6 and 7
of Example 5.17, which follows shortly, illustrate the elimination entries required where a final
dividend is payable by a subsidiary and there is a non-controlling interest involved.
3. Measurement of non-controlling interest

IFRS 10 requires the presentation of any non-controlling interest in the consolidated statement
of financial position within equity (IFRS 10, para. 22). The non-controlling interest must be
presented separately from the equity of the owners of the parent.
As discussed in Module 2, IAS 1 requires the profit or loss and other comprehensive income to
be allocated to the owners of the parent and to the non-controlling interest (IAS 1, para. 81B).
The non-controlling interest in the net assets of consolidated subsidiaries should consist of:
• the amount of the non-controlling interest at the date of the original combination calculated
in accordance with IFRS 3 (i.e. pre-acquisition equity)
• the non-controlling interest’s share of changes in equity since the date of the combination
(i.e. post-acquisition changes in equity) (IAS 1, para. 81B).
At acquisition, the non-controlling interest is measured at its share of the fair value of the
identifiable net assets of the subsidiary (one available option in accordance with IFRS 3, para. 19).
IFRS 10 does not indicate how to measure the non-controlling interest’s share of movements
in equity. However, the general principle is that the non-controlling interest should be measured
as its portion of the aggregate amount of the equity of the subsidiaries adjusted for unrealised
profits or losses of subsidiaries.
If you wish to explore this topic further you may now read IFRS 10, paras 22 and B94.
The rationale for requiring a non-controlling interest to be adjusted for the unrealised profits or
losses of a subsidiary stems from the entity concept of consolidation, which sees a non‑controlling
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interest as an owner in the group. Determining a non-controlling interest focuses on its share of
the equity of the group, not its share of the equity recorded in the financial statements of the
subsidiary. The equity of the group is affected by the elimination of intra-group profits or losses.
As such, the calculation of a non-controlling interest must also be adjusted for unrealised profits
or losses relevant to it. To determine which intra-group transactions affect the measurement of
a non‑controlling interest, there are two important points to remember.
First, as a non-controlling interest has an interest in the group via the subsidiary, only intra‑group
transactions that affect the subsidiary’s equity require adjustment. Thus the original intra‑group
transaction leading to unrealised profits or losses must have been from the subsidiary.
For example, if the subsidiary sold plant at a profit to the parent, the profit would be reflected
in the P&L and retained earnings of the subsidiary. However, from the group’s perspective,
this profit is unrealised and should be eliminated. Thus, the profit or loss and relevant income and
expense items in the financial statements of the subsidiary must be adjusted for the unrealised
profit on the plant to reflect the profit recognised by the group. This adjusted subsidiary profit
then forms the basis of calculation for the non-controlling interest. It is important to remember
that if the intra-group transaction has been a sale of plant from the parent to the subsidiary,
there is no effect on the equity of the subsidiary (only on the equity of the parent), and the
non‑controlling interest has no interest in the parent. Therefore, for the intra-group transactions
from the parent to the subsidiary, no adjustments are required to the subsidiary equity-account
balances to enable the non-controlling interest to be calculated.
The second point to note is the requirement to understand which transactions lead to unrealised
profits or losses from the perspective of the group. As previously discussed, unrealised profits or
losses only arise through an intra-group sale of assets such as inventory, plant and land. Profits or
losses from the intra-group sale of those assets are realised by the group when a party external
to the group is involved. For other intra-group transactions (dividends, interest and services), it is
assumed, from a practical viewpoint, that the profits or losses are realised immediately as the net
effect of those transactions on the consolidated profit is nil.
In summary, measuring the amount of non-controlling interest in a consolidated equity item

involves applying the relevant non-controlling interest percentage to the book value of the
subsidiary equity account involved, adjusted where relevant for realised/unrealised profits/
losses that resulted from a sale of an asset from the subsidiary to the parent.
Example 5.16 demonstrates the application of this measurement principle where there is an intra-
group sale of inventory resulting in an unrealised profit. Question 5.17, following Example 5.16,
applies the measurement principle for non-controlling interests in the subsequent reporting
period when the inventory is sold to parties external to the group and the profit is realised.
Example 5.16 relates to Case study 5.3 contained in Appendix 5.1 and focuses on the data
for the year ended 30 June 20X4.
Example 5.16: Measurement of non-controlling interest

Example 5.16 is concerned with measuring the non-controlling interest in the following consolidated
items: opening retained earnings, profit for the year and closing retained earnings.
As the parent owns 70 per cent of the shares in the subsidiary, the non-controlling interest is entitled
to 30 per cent of the subsidiary’s equity as it is reflected in the consolidated equity.
To determine the non-controlling interest in the consolidated opening retained earnings, the starting
point is the opening retained earnings of Subsidiary Ltd (Subsidiary). The next consideration is to
determine whether there have been any transactions that have impacted on the opening retained
earnings of Subsidiary but have been eliminated on consolidation. In Case study 5.3, there are no
fair value adjustments for assets or liabilities not recorded at fair value at acquisition date and no
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unrealised profits/losses carried forward from the year ended 30 June 20X3. Hence, there is no need
to make any adjustments to the opening retained earnings in the financial statements of Subsidiary.
Non-controlling interest in opening retained earnings account:

= 30% of opening retained earnings balance in financial statements of Subsidiary
= 30% of $40 000
= $12 000
To measure the non-controlling interest in the consolidated profit, the starting point is again the relevant
item in the financial statements of Subsidiary, that is, the profit of Subsidiary. Then, it is necessary to
determine whether there have been any transactions that have affected the profit of Subsidiary but
have been eliminated on consolidation.
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Case study 5.3 contains three intra-group transactions for the year ended 30 June 20X4. Both the
sale of the inventory from Subsidiary to Parent Ltd (Parent) and the sale of the plant from Parent to
Subsidiary would require the elimination of unrealised profits from the group’s perspective. There is no
unrealised profit on the provision of management services. From Subsidiary’s point of view, the profit
on the sale of inventory is the only one of the three transactions that has impacted on its 20X4 profit
but not on the consolidated profit. Hence, this item should be taken into account when calculating
the non-controlling interest in the consolidated profit. The non-controlling interest has an interest in
the consolidated profits via the profits of Subsidiary, but the profit on the sale of inventory to Parent
has been eliminated by the group. The non-controlling interest can only receive its share of the profit
of Subsidiary when it is included in the consolidated profit of the group.
Non-controlling interest in profit:

= 30% of (Profit in financial statements of Subsidiary – Unrealised after-tax profits made by Subsidiary)
= 30% of (Profit in financial statements of Subsidiary – Unrealised profit on sale of inventory + Tax
effect of unrealised profit)
= 30% of ($200 000 – $40 000 + $12 000)
= 30% of $172 000
= $51 600
As the unrealised profit on the sale of inventory from Subsidiary to Parent has been eliminated from the
consolidated profit, it must have also been eliminated from the consolidated closing retained earnings.
Hence, the unrealised profit must be taken into account when determining the non-controlling interest’s
share of the consolidated closing retained earnings.
Non-controlling interest in closing retained earnings:

= 30% of (Closing retained earnings of Subsidiary – Unrealised after-tax profits made by Subsidiary)
= 30% of (Closing retained earnings of Subsidiary – Unrealised profit on sale of inventory + Tax effect
of unrealised profit)
= 30% of ($140 000 – $40 000 + $12 000)
= 30% of $112 000
= $33 600
An alternative way of reconciling the non-controlling interest in closing retained earnings is by using
the individual items making up the balance:
= Non-controlling interest in opening retained earnings + Non-controlling interest in profit –
Non‑controlling interest in dividends
= $12 000 + $51 600 – $30 000 (30% of $100 000)
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= $33 600

➤➤Question 5.17
Refer to Case study 5.3 in Appendix 5.1. Using data for the year ended 30 June 20X5,
measure the non-controlling interest in the following: opening retained earnings, profit and
closing retained earnings.
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Now that the discussion of non-controlling interest is completed, please refer to the Learning
Task: Measurement of NCI on My Online Learning for further practice on measurement of
non‑controlling interest.
Example 5.17 relates to Case study 5.4. You may now read the data in Case study 5.4 in
Appendix 5.1.
Study guide | 429
The purpose of Example 5.17 is to provide an overview example that demonstrates the
application of the following consolidation principles:
• elimination of the investment in the subsidiary and the parent’s share of the equity of the
subsidiary at acquisition date
• elimination in full of all intra-group assets, liabilities, revenues and expenses including profits
or losses on the transfer of assets within the group
• measurement of non-controlling interest by applying the non-controlling interest percentage
to the carrying amount of the subsidiary equity adjusted for unrealised/realised profits or
losses from the sale of an asset from the subsidiary to the parent.
Example 5.17: Comprehensive consolidation

The first task is to analyse the Case study 5.4 data and prepare consolidation elimination entries.
The elimination entries and their rationale are outlined here.
1. On 1 July 20X0, Parent Ltd (Parent) purchased 70 per cent of the issued capital of Subsidiary Ltd
(Subsidiary) for $120 000. An extract from the equity section of the statement of financial position
of Subsidiary at the acquisition date reveals the following:
$
150 000

At the acquisition date, the identifiable net assets of Subsidiary were recorded at fair value. Thus,
the fair value of identifiable net assets at the acquisition date is equal to the value of total equity
recorded in the statement of financial position of Subsidiary (assuming no goodwill previously
recorded). The value of non-controlling interest at acquisition date is calculated based on the
proportionate share of identifiable net assets.
Goodwill on consolidation would be calculated as follows:
$
Fair value of consideration transferred 120 000
Non-controlling interest (30% of $150 000) 45 000
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165 000
Less: Fair value of identifiable net assets (150 000 )
Goodwill 15 000
In accordance with IFRS 10, para. B86(b), the investment in the subsidiary must be eliminated in full
together with the parent’s share of the subsidiary’s equity. Therefore, the following pre-acquisition
elimination entry (1) is required:
Dr Cr
$ $
Goodwill 15 000
2. During the financial year ended 30 June 20X1, Parent sold inventory with a cost of $5000 to
Subsidiary for $9000. The inventory was still on hand as at 30 June 20X1.

The entry processed by Parent for the sale of the inventory would be:
Dr Cr
$ $
Bank 9 000
Sales 9 000
Inventory 5 000
The entry processed by Subsidiary for the purchase of the inventory would be:
Dr Cr
$ $
Inventory 9 000
Bank 9 000
From the group’s perspective, these entries do not relate to parties external to the group and,
hence, the effect should not be reflected in the consolidated financial statements. That is,
the intra-group sale and cost of goods sold must be eliminated (which eliminates the profit
on the transaction) and the inventory must be restated to the cost to the group. Therefore,
the following consolidation elimination entry (2a) is required:
Dr Cr
$ $
Sales 9 000
Inventory 4 000
To explain each line of this entry, the debit to Sales eliminates the credit to Sales recorded by
Parent upon the sale of inventory to Subsidiary. Similarly, the credit to Cost of goods sold eliminates
the debit to Cost of goods sold previously recorded by Parent at the time of sale. The credit to
Inventory of $4000 offsets the ‘net’ debit to Inventory recorded by both Parent and Subsidiary at
the time of sale (i.e. $9000 debit recorded by Subsidiary minus $5000 credit recorded by Parent
equals $4000 ‘net’ debit) and makes sure that inventory is recorded at the original cost to the
group. No entry is required for Bank as the debit recorded by Parent at the time of sale has already
been offset by the credit recorded by Subsidiary.
This consolidation elimination entry requires the following tax effect entry (2b):
Dr Cr
$ $

As the group has eliminated $4000 of unrealised profit (i.e. by debiting Sales of $9000 and crediting
Cost of goods sold of $5000), the income tax expense of the group must be reduced by $1200
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(30% of $4000). As such, the unrealised after-tax profit on sale of inventory is $2800 ($4000 – $1200).
The deferred tax asset of $1200 arises because the tax paid on the intra-group profit by the parent
is a prepayment of tax from the group’s perspective, giving rise to a tax benefit available for the
future (i.e. the group will not have to pay tax again when profit will be realised for the group).
3. Over the financial year, Parent had charged Subsidiary $3000 for services rendered. The services
had not been paid for by the end of the financial year.
Parent processed the following entry for the services rendered:
Dr Cr
$ $
Other income 3 000
Subsidiary processed the following entry for the services received:
Dr Cr
$ $
Expenses 3 000

From the group’s perspective, this transaction is an internal one and must be eliminated.
Therefore, the following consolidation elimination entries (3 and 4) are required:
Study guide | 431
Consolidation elimination entry 3:

Dr Cr
$ $
Other income 3 000
Expenses 3 000

Dr Cr
$ $
Note: There is no tax effect for these elimination entries, as they do not have any net impact on the
consolidated profit. This is because the amount of ‘Other income’ eliminated equals the amount
of ’Expenses’ eliminated, meaning that the effect of these elimination entries on consolidated
profit is nil.
4. On 30 June 20X1, Subsidiary sold plant to Parent for $16 000 at a loss of $4000. The plant had a
remaining useful life of two years with a scrap value of $2000 at the end of that time.
Subsidiary processed the following entry for the sale of the plant:
Dr Cr
$ $
Bank 16 000
Other income (loss) 4 000
Plant 20 000
Note: The plant was sold for $16 000 at a loss of $4000. The carrying amount of the plant in
Subsidiary’s statements was, therefore, $20 000 (Carrying amount $20 000 – Sale price $16 000 =
$4000 loss).
Parent processed the following entry for the purchase of the plant:
Dr Cr
$ $
Plant 16 000
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Bank 16 000

From the group’s perspective, the intra-group loss on the sale of the plant should be eliminated
and the amount of the plant should be increased to the cost to the group. Therefore, the following
consolidation elimination entry (5a) is required:
Dr Cr
$ $
Plant 4 000
Other income 4 000
In this entry, the debit to Plant of $4000 offsets the ‘net’ credit to Plant recorded by both Parent
and Subsidiary at the time of sale (i.e. $20 000 credit recorded by Subsidiary minus $16 000 debit
recorded by Parent equals $4000 ‘net’ debit) and brings the Plant to the original carrying amount.
The credit to Other income eliminates the debit to Other income previously recorded by Subsidiary
at the time of sale to recognise the loss. No entry is required for Bank as the debit recorded by
Parent at the time of sale has already been offset by the credit recorded by Subsidiary.
The preceding elimination entry requires the following tax effect entry (5b):
Dr Cr
$ $
As the group has eliminated the unrealised loss of $4000, the consolidated profit increases
and the income tax expense of the group must be increased by $1200 (30% of $4000). As such,
the unrealised after-tax loss on plant is $2800 ($4000 – $1200). In addition, the group has a deferred
tax liability of $1200. That is, the group does not have to pay the tax itself, but the individual entities
will pay it when their profit does not include this loss. In other words, as a result of the increase in
the carrying amount of Plant in elimination entry (5a), a taxable temporary difference arises and,
consequently, gives rise to a deferred tax liability.
5. On 30 June 20X1, Subsidiary declared a final dividend of $10 000. Parent recognises dividend
income when it is receivable.
Subsidiary processed the following entry for the dividend declared:
Dr Cr
$ $
Final dividend (retained earnings) 10 000
Parent processed the following entry in relation to the dividend declared by Subsidiary:
Dr Cr
$ $
Dividend receivable 7 000
Dividend income† 7 000
†
Parent owns 70 per cent of the shares in Subsidiary and, therefore, is entitled to 70 per cent of the
final dividend declared by Subsidiary. The remaining 30 per cent is owned by the non-controlling
interest shareholders.
From the group’s perspective, the effects of the intra-group dividend should be eliminated.
Therefore, the following consolidation elimination entries (6 and 7) are required:

Dr Cr
$ $
Dividend income 7 000
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Dr Cr
$ $
There are no tax consequences for these consolidation elimination entries related to the dividend
because the dividend is tax-free to Parent, and the income tax expense of Parent will reflect this.
Note that entry 7 does not eliminate the non-controlling interest’s share in the dividend (i.e. 30%
× $10 000 = $3000) because this relates to shareholders external to the group.
After determining the consolidation elimination entries for this comprehensive example that were
discussed on the preceding pages, these can now be processed in the consolidation worksheet.
The following consolidation worksheet is prepared and includes the non-controlling interest
allocation (the calculation of non-controlling interest is discussed after the worksheet). The financial
statement amounts of Parent and Subsidiary are pre-determined. Notes in the worksheet refer to
the numbered consolidation elimination entries in bold that were discussed in the preceding pages.
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Eliminations Non- Parent

adjustments Consoli- controlling equity
Parent Subsidiary Dr Cr dated interest interest
Consolidation worksheet $000 $000 $000 $000 $000 $000 $000
Sales 320 95 9(2a) 406†
Less: Cost of goods sold (150) (35) 5(2a) (180)
Gross profit 170 60 226
Less: Expenses (80) (16) 3(3) (93)

90 44 133
Dividend income 7 7(6) —
Other income 3 (4) 3(3) 4(5a) —

Less: Income tax expense (30) (12) 1.2 (5b)
1.2 (2b)
(42)
Profit for the year 70 28 91 9.24 81.76

Retained earnings
220 50 35(1) 235 15 220
1 July 20X0
290 78 326 24.24 301.76
Less: Final dividend (20) (10) 7(6) (23) (3) (20)

Retained earnings
270 68 303 21.24 281.76
30 June 20X1
Issued capital 400 100 70(1) 430 30 400
Total equity 733 51.24 681.76
Liabilities
Trade payables 20 11 3(4) 28
Final dividend payable 20 10 7(7) 23
Other 84 50 134
Deferred tax liability 1.2(5b) 1.2
Total equity and liabilities 794 239 919.2
Current assets
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Dividend receivable 7 7(7) —
Trade receivables 35 14 3(4) 46
Inventory 60 25 4(2a) 81
Other 100 30 130
Non-current assets
Plant (net) 250 100 4(5a) 354
Other 222 70 292
Investment in Subsidiary 120 120(1) —
Goodwill 15 (1)
15
Deferred tax asset 1.2(2b) 1.2
Total assets 794 239 155.4 155.4 919.2

†
Parent’s sales of $320 000 + Subsidiary’s sales of $95 000 – Elimination (debit) of $9000 = Consolidated sales
of $406 000. This approach is applicable throughout the worksheet based on normal debit and credit rules.
Calculation of non-controlling interest

• Non-controlling interest in Subsidiary’s opening retained earnings:
= 30% of opening retained earnings balance in financial statements of Subsidiary
= 30% of $50 000
= $15 000

The opening retained earnings of Subsidiary represents the balance of this item at the acquisition date.
No intra-group transactions from Subsidiary to Parent had taken place.
• Non-controlling interest in Subsidiary’s profit after tax for the year (adjusted for profit or loss on
intra-group transactions):
= 30% of (Profit for the year in financial statements of Subsidiary – (+) Unrealised after-tax profits
(losses) made by Subsidiary + (–) Realised after-tax profits (losses) made by Subsidiary)
= 30% of (Profit for the year in financial statements of Subsidiary + Unrealised after-tax loss
on plant)
= 30% of ($28 000 + ($4000 – $1200))
= 30% of $30 800
= $9240

Remember that the measurement of non-controlling interest involves applying the relevant
non‑controlling interest percentage to the carrying amount of the subsidiary equity adjusted
for unrealised/realised profits/losses that resulted from a sale of an asset from the subsidiary
to the parent. For the comprehensive example, the relevant non-controlling interest percentage is
30 per cent. The focus is on the non-controlling interest share of profit and, therefore, the appropriate
starting point is the profit for the year in the financial statements of the subsidiary ($28 000).
However, the profit of Subsidiary includes the after-tax loss on the sale of the plant by Subsidiary
to Parent. From the group’s perspective, this was an internal transaction and the unrealised loss and
associated tax effects were eliminated (refer to entries 5a and 5b in the consolidation worksheet). As the
group has not recognised the loss (net of tax), the non-controlling interest should not be allocated a
share of this item. The profit of Subsidiary is adjusted by adding back the unrealised loss and eliminating
the associated tax effects that resulted from the sale of the plant by Subsidiary to Parent.

Note: Even though the intra-group sale of inventory is reflected in the statement of financial position
of Subsidiary, Parent recorded the profit on the sale. Hence, the non-controlling interest shareholders of
Subsidiary have no interest in this profit or its elimination.
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• Non-controlling interest in Subsidiary’s closing retained earnings:

This amount can be calculated in two ways:
1. The calculations of the individual items making up the closing balance of retained earnings:
= Non-controlling interest in Subsidiary’s opening retained earnings + Non-controlling
interest in Subsidiary’s profit after tax (adjusted for profit or loss on intra-group
transactions) – Non-controlling interest in final dividend declared by Subsidiary:
= $15 000 + $9240 – (30% of $10 000)
= $15 000 + $9240 – $3000
= $21 240
2. Using the closing balance of the retained earnings of Subsidiary – (+) Any after-tax unrealised
profits (losses) made by Subsidiary:
= 30% of ($68 000 + ($4000 – $1200))
= 30% of ($68 000 + $2800)
= 30% of $70 800
= $21 240

Study guide | 435
The loss on the sale of the plant by Subsidiary to Parent is included in the closing retained earnings
balance of Subsidiary via Subsidiary’s profit. The loss is unrealised from the group’s point of view.
Therefore, determining the non-controlling interest in the closing retained earnings of the group by
starting with the closing balance of the retained earnings of Subsidiary requires an adjustment (add‑back)
for the unrealised loss, net of the tax effect.
• Non-controlling interest in Subsidiary’s issued capital:

= 30% of $100 000
= $30 000
• Non-controlling interest in statement of financial position:

= Non-controlling interest in Subsidiary’s issued capital (as calculated above) + Non-controlling
interest in Subsidiary’s closing retained earnings (as calculated above) + Non-controlling interest in
Subsidiary’s reserves
= $30 000 + $21 240 + $0
= $51 240
Note that as the net assets of Subsidiary were recorded at fair value, there is no business combination
reserve. If there was, the non-controlling interest share of this item would also have to be taken into account.
➤➤Question 5.18
Question 5.18 extends Example 5.17. One year later, on 30 June 20X2, the following information
and worksheet data were available for Parent and Subsidiary:
Required:
(a) Complete the consolidation worksheet.
Note: Remember to use any relevant information relating to the 20X1 year from the
comprehensive example (Example 5.17).
(b) Explain how the non-controlling interest was arrived at.
Additional information:
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1. During the financial year ended 30 June 20X2, half of the inventory sold by Parent  to
Subsidiary in the previous financial year was sold to parties external to the group. On 15 June
20X2, Subsidiary sold inventory to Parent for $8000 that had cost $4000. Parent still had
this inventory on hand at the end of the financial year.
2. Over the financial year, Parent had charged Subsidiary $4000 for services rendered; $1000
of the services had not been paid for by the end of the financial year.
3. The plant sold by Subsidiary to Parent on 30 June 20X1 was depreciated by $7000 in the
financial statements of Parent during the 20X2 financial year. That is, a straight-line basis of
depreciation was adopted.
4. During the financial year, Subsidiary paid an interim dividend of $10 000. On 30 June 20X2,
Subsidiary declared a final dividend of  $10 000. Parent  recognises dividend income when
it is receivable.
5. The directors of Parent and Subsidiary decided to transfer $20 000 and $10 000 respectively
from their respective pre-acquisition retained earnings to a general reserve.
6. Assume a tax rate of 30 per cent.

Sales 400 150

Less: Cost of goods sold (210) (70)

Gross profit 190 80
Less: Expenses (88) (30)
102 50
Dividend income 14 —
Other income 4 —
Less: Income tax expense (36) (15)
Retained earnings 1 July

270 68
20X1
354 103
Less:
Interim dividend (10) (10)

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Final dividend (20) (10)
Transfer to general reserve (20) (10)

Retained earnings
304 73
30 June 20X2
General reserve 20 10
Total equity 724 183

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Liabilities
Other 79 52
Total equity and liabilities 848 260
Current assets
Dividend receivable 7
Inventory 65 22
Other 171 60
Non-current assets
Plant (net) 230 90
Other 215 70
Investment in Subsidiary 120
Goodwill
Deferred tax asset
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Total assets 848 260
Disclosures: Consolidated financial statements

To conform with the requirements of IAS 1, para. 10, consolidated financial statements would
comprise the following five items:
1. a consolidated statement of financial position
2. a consolidated statement of profit or loss and other comprehensive income
3. a consolidated statement of changes in equity
4. a consolidated statement of cash flows (in accordance with IAS 7 Statement of Cash Flows)
5. notes including accounting policies and explanatory notes.
Consolidated statement of financial position

Consistent with the entity concept, a consolidated statement of financial position should
recognise all the assets and liabilities under the control of the group, and any non-controlling
interest (if relevant) has to be displayed as part of equity. As discussed previously, IFRS 10
requires the consolidated statement of financial position to separately recognise the equity
attributable to the owners of the parent and that attributable to the non-controlling interest
(IFRS 10, para. 22). The consolidated statement of financial position should comply with the
disclosure requirements of IAS 1, para. 54.
Before continuing, if you wish to explore this topic further you may read:
• IFRS 10, para. 22
• IAS 1, para. 54 to review the disclosures required on the face of a statement of financial position
• the example of a consolidated statement of financial position in Part I of the ‘Guidance on
implementing IAS 1 Presentation of Financial Statements’ section of IAS 1 (Part B of the
Red Book).
Consolidated statement of profit or loss and other

IAS 1 requires a complete set of financial statements to include a P&L and OCI (IAS 1, para. 10).
A consolidated P&L and OCI must present both the components of the profit or loss and the
components of other comprehensive income (IAS 1, paras 82 and 82A). IAS 1 also requires the
P&L and OCI to disclose both the non-controlling interests share and the owners of the parent
share of:
• profit or loss for the period
• total comprehensive income for the period (IAS 1, para. 81B).
• IAS 1, paras 81A, 81B, 82 and 82A to review the disclosures required for a P&L and OCI
• the examples of a consolidated P&L and OCI in Part I of the ‘Guidance on implementing
IAS 1 Presentation of Financial Statements’ section of IAS 1 (note the non-controlling interest
disclosures) (Part B of the Red Book).
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Consolidated statement of changes in equity

Changes in the group’s equity during the reporting period should be presented in a consolidated
statement of changes in equity that complies with the disclosure requirements of IAS 1, paras 106,
106A and 107. The statement of changes in equity must present the total comprehensive income
and the amounts attributable to the non-controlling interests and the owners of the parent
(IAS 1, para. 106(a)).
• IAS 1, paras 106 and 107 to review the disclosures required for a statement of changes in equity
• the examples of a consolidated statement of changes in equity in Part I of the ‘Guidance on
implementing IAS 1 Presentation of Financial Statements’ section of IAS 1 (note the non‑controlling
interest disclosures) (Part B of the Red Book).

Study guide | 439
➤➤Question 5.19
Refer to the worksheet prepared in answering Question 5.18 and the information in Example 5.17
to prepare the following statements in accordance with the disclosure requirements of IAS 1:
(a) Prepare a consolidated P&L and OCI.
(b) Prepare a consolidated statement of changes in equity.
(c) Prepare a consolidated statement of financial position.
Consolidated statement of cash flows

Another financial statement the group is required to prepare is a consolidated statement
of cash flows. This will have to be prepared in accordance with IAS 7, including any
Notes including accounting policies and explanatory notes

In addition to the disclosures required by IAS 1, IFRS 12 requires entities to disclose information
about interests in subsidiaries. The general objective of IFRS 12 is to help financial statement
users to assess:
• the nature of, and risks involved with, an entity’s interests in other entities
• the effects of those interests on the entity’s financial position, financial performance and
cash flows (IFRS 12, para. 1).
To satisfy the objective of IFRS 12, entities with an interest in a subsidiary must disclose
information that focuses on:
• significant judgments and assumptions in determining that control exists over the other
entity (IFRS 12, paras 7–9)
• the composition of the group and the interests that non-controlling interests have in the
group’s activities and cash flows (IFRS 12, paras 10(a) and 12)
• details of any restrictions on the entity being able to access or use the group’s assets or settle
its liabilities (IFRS 12, paras 10(b)(i) and 13)
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• the consequences of changes in the entity’s ownership interest in a subsidiary which did not
lead to a loss of control (IFRS 12, paras 10(b)(iii) and 18)
• the consequences of the entity losing control of a subsidiary (IFRS 12, paras 10(b)(iv) and 19).
If you wish to explore this topic further you may now read IFRS 12, paras 1, 7–13, 18 and 19.
Summary
IFRS 10 specifies the requirements for the preparation of consolidated financial statements based
on the underlying principle to present the financial performance, position and the financing
and investing activities of a group (comprising the parent entity and all of its subsidiaries) as a
separate economic entity.
Consolidated financial statements are prepared by aggregating the financial statements of entities
comprising the group. This aggregation process may involve a number of adjustments including:
• adjusting the financial statements of individual entities where they have been prepared using
dissimilar accounting policies or reporting periods ending on different dates
• elimination of pre-acquisition equity balances (after revaluation of subsidiary assets to fair
value) of a subsidiary where the parent entity has an ownership interest in the subsidiary
• elimination of the effects of all transactions between all entities within the group.
Where a parent entity has less than 100 per cent ownership in its subsidiaries, the non‑controlling
interest must be measured by aggregating its proportionate share in the equity of the subsidiaries
after adjusting for the unrealised profits or losses of the subsidiaries.
The disclosure requirements for consolidated financial statements are contained in:
• IAS 1
• IFRS 10, para. 22—non-controlling interests
• IFRS 12—additional disclosures apart from the financial statements.
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Study guide | 441
Part C: Investments in associates

Introduction
Part C is concerned with accounting for investments in other entities that do not lead to control,
but provide the investor with significant influence over the investee. ‘Significant influence’ is
defined in IAS 28, para. 3 as ‘the power to participate in the financial and operating policy
decisions of the investee but is not control or joint control of those policies’. The investee in this
type of relationship is known as an ‘associate’. The ‘equity method’ was developed to account for
such investments and it involves recognising the investor’s share of the post-acquisition change in
net assets (i.e. equity) of the associate. As such, it provides more information than just recognising
the investment based on cost, but less than what would be provided if the consolidation method
were used. The equity method is often referred to as a ‘one‑line consolidation’ method because
the entries prepared (to recognise the investor’s share of the net assets of the associate at
acquisition date and any changes thereof) are recorded to recognise a single asset (investment in
associate) in its statement of financial position, with many of the procedures used mirroring the
consolidation procedures described in IFRS 10 (but without being entirely consistent with them—
more on that later). Moreover, the profit or loss of the investor includes its share of the profit or
loss of the investee (presented as a line item of income) and the OCI of the investor includes its
share of OCI of the investee (presented as a line item of OCI).
IAS 28 prescribes how to account for investments in associates using the equity method
(IAS 28, para. 1). IFRS 12 specifies the disclosure requirements where an entity has an interest in
an associate. These accounting standards will be addressed in this section from the perspective
of the underlying principles applicable when accounting for investments in associates.
If you wish to explore this topic further you may now read IAS 28, paras IN3–6, which expand on
this discussion. You may also wish to read IAS 28, para. 11, which outlines the rationale for using
the equity method to provide additional information to financial statements users where an investor
has significant influence or joint control over another entity.
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Relevant paragraphs
To assist you in achieving the objectives specified in this module, you may wish to read these
paragraphs. Where specified, you need to be able to apply the following paragraphs of IAS 28
and IFRS 12.
Subject Paragraphs
IAS 28 Investments in Associates and Joint Ventures
Introduction IN1–8
Objective 1
Scope 2
Definitions 3–4
Significant influence 5–9
Equity method 10–15
Application of the equity method 16–39
IFRS 12 Disclosure of Interests in Other Entities

Objective 1–4
Significant judgements and assumptions 7–9
Interests in joint arrangements and associates 20–3
Appendix B: Application guidance B12, B14–16
In addition, you must be familiar with and, where appropriate, able to apply IFRS 3, paras 32–40.
Identifying associates
If an investor has the power to take part in decisions regarding the financial and operating
policies of the investee, but it doesn’t control the investee, it is said to have significant influence
over the investee (IAS 28, para. 3). Importantly, it is the power to participate, regardless of
whether it is active participation or a passive investment. To recognise the close relationship
that exists in this situation between the investor and the investee, the investee is identified as
being an associate of the investor.
IAS 28, paras 5–9 expand on the principle captured in this definition by providing guidance for
the determination of whether an investor has significant influence over an investee.
Significant influence would normally stem from the investor having 20 per cent or more of
the voting power, but less than 50 per cent (IAS 28, para. 5). It is important to note, however,
that the 20 per cent test, as with the whole question of determining whether significant
influence exists, should be decided in light of all prevailing circumstances. That is, substance
should prevail over form. Significant judgments and assumptions made in determining whether
significant influence exists must be disclosed in accordance with IFRS 12, para. 7(b).
Even though the investor may hold more than 20 per cent of the voting power, the absence of
significant influence may stop the investor from gaining board representation, thereby denying
participation in the decision-making processes of the investee. Likewise, the investor may
have significant influence but still not hold 20 per cent of the voting power. As an example,
voting power may be widely distributed among other equity holders, allowing the investor
sufficient command to influence the election of directors (similar to the situation discussed in
the context of factors influencing control in Part B). Alternatively, significant influence may exist
because the investor is a major supplier of essential technical information.
Finally, in some situations, an entity owns share options or other instruments that are convertible
into ordinary shares, or has similar instruments, which, if exercised or converted, would increase
the entity’s voting power, or reduce another entity’s voting power, over the financial and
operating policies of another entity.
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Therefore, when assessing whether an entity has significant influence, the existence and effect
of such potential voting rights should be taken into account. However, this assessment will only
take into account potential voting rights that are presently exercisable or presently convertible
(IAS 28, para. 7). Potential voting rights that cannot be exercised or converted until a future
date should not be taken into account. Consideration of potential voting rights in determining
significant influence requires judgment, although this does not extend to determining:
• management’s intention to exercise or convert the financial instrument
• the financial ability of the entity to exercise or convert the financial instrument
(IAS 28, para. 8).
IAS 28, para. 6 lists some of the other factors that, singly or in combination, may indicate that
the investor has significant influence, including:
• representation on the board of directors (or equivalent governing body);
• participation in policy making;
• material transactions between investor and investee;
• interchange of managerial personnel; and
• provision of essential technical information (IAS 28, para. 6).
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• the definitions of ‘associate’ and ‘significant influence’ contained in IAS 28, para. 3
• IAS 28, paras 5–9.
In addition, you may also wish to read IFRS 12, paras 7–9, which deal with the disclosure of significant
judgments and assumptions made in determining significant influence.
➤➤Question 5.20
Comment on whether the following accounting policy is in accordance with IAS 28:
Associates are those entities in which the group has a shareholding between 20 per cent
and 50 per cent of the issued capital.
Use of equity method

IAS 28, para. 16 requires an investment in an associate to be accounted for using the equity
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method, subject to the exemptions specified in paras 17–19.
If you wish to explore this topic further you may now read IAS 28, paras 17–19.
It should also be noted that if the investor does not prepare consolidated financial statements
(because it does not have investments in subsidiaries), then the investment in the associate
is accounted for using the equity method in the only financial statements that the investor
has to prepare (i.e. their own). However, if the investor is a parent for some subsidiaries and
therefore prepares consolidated financial statements, the investment account in the associate
should appear in the consolidated financial statements as if the equity method of accounting
was applied to account for it. This implies that the investment account may be recognised
under another method (e.g. cost method) in the individual accounts of the investor and,
on consolidation, adjustments will be posted to adjust the accounts impacted so that they
reflect the investment as it would have been accounted for using the equity method.
This module assumes that the investor prepares consolidated financial statements and applies
the equity method for associates in those financial statements. In addition, the module assumes
that the investor accounts for the investment in the associate in its own financial statements
using the cost method.
Basis of equity method

The focus of Part C of this module is the equity method, which involves recognising the investment
in the associate originally at cost and then adjusting its carrying amount for the investor’s share
of any changes post-acquisition in the associate’s equity, including changes that result from the
associate’s profit or loss, dividends and other comprehensive income (IAS 28, para. 3).
Note: The investment in an associate in the manner described here will usually give rise to a
taxable temporary difference post-acquisition between the carrying amount of the investment
(that will be increased by the investor’s share of post-acquisition increases in the equity of the
investee) and its tax base (often its original cost). This module does not deal with any deferred
tax liability that arises for the investment in an associate.
Prior to discussing in detail the application of the equity method, it is appropriate to briefly
consider the methodology underlying the equity method. This is done below by comparing it to
the other method that can be used to account for investments in other entities that do not result
in control—the cost method.
If you wish to explore this topic further you may now read IAS 28, para. 10, which briefly discusses
‘the equity method’.
There are two key differences between accounting for an investment using the cost method
versus the equity method.
First, the cost method recognises the investment as an asset in the investor’s accounts based on
the amount originally invested in the associate, while the amount recognised under the equity
method for the investment asset is the amount originally invested plus the investor’s share of all
undistributed profits or losses and OCI in the periods after acquisition (i.e. items that essentially
cause changes in the investee’s equity). As discussed in Module 2, OCI includes items of income
and expense that ‘are not recognised in profit or loss as required or permitted by other IFRSs’
(IAS 1, para. 7). OCI includes items such as changes in revaluation surpluses, or exchange
difference gains and losses on translating the financial statements of a foreign operation.
The second key difference between accounting for an investment using the cost method and
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the equity method is that, under the cost method, dividends received by the investor from the
investee will be treated as dividend income, while when applying the equity method, they form
part of calculating the changes in the investee’s equity that will impact on the carrying amount of
the investment, as discussed above.
These differences illustrate that the focus of the equity method is on the investor’s share of,
and changes in, the equity (net assets) of an associate. By using the equity method, the equity
investment is measured at the cost of acquisition plus the investor’s share of post-acquisition
changes in the equity (net assets) of the associate.
The previous discussion also helps identify the reasons for the equity method being the
preferred method in accounting for an equity investment that brings significant influence over
an investee. First of all, as the investor has significant influence over the investee, the investor is
entitled to a share of the performance (i.e. post-acquisition profits) of the investee, which should
increase the investor’s overall performance. The equity method, as opposed to the cost method,
requires the investor to recognise its share of the associate’s performance and therefore helps
provide more informative disclosures about the investor’s own performance. Only recognising
the investor’s share of the investee’s profits distributed via dividends (according to the cost
method) may not adequately reflect the investee’s performance that should be allocated to the
investor. For example, if the associate does not declare any dividends, it does not mean that
the investor cannot benefit from the performance of the associate.
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Example 5.18: Comparison of cost method and equity method

Assume that Investor Ltd (Investor) purchased 30 per cent of the issued capital of Investee Ltd (Investee)
for $30 000 on 1 July 20X1. At that date the statement of financial position of Investee was as follows:
$ $
Net assets 100 000 Retained earnings 50 000
100 000 100 000
The net assets of Investee (assuming all are identifiable) were measured at their fair value. Therefore,
the consideration paid by Investor equalled its share of the identifiable net assets (i.e. 30% × $100 000)
and no goodwill was purchased. In the financial statements of Investor, the asset ‘Investment in Investee’
would be recorded at $30 000.
Assume a tax rate of 30%.
The P&L and OCI of Investee for the financial year ended 30 June 20X2 revealed the following:
• a profit of $50 000
• a dividend payment of $15 000
• OCI of $7000 after tax relating to the revaluation of a non-current asset by $10 000 (the revaluation
reflects an increase in the fair value of a non-current asset since 1 July 20X1 and will be accumulated
in revaluation surplus).
The statement of financial position of Investee as at 30 June 20X2 revealed the following:
$ $
Retained earnings 85 000 †
Net assets 142 000 ‡ Revaluation surplus 7 000
142 000 142 000
†
$50 000 + $50 000 (profit) – $15 000 (dividend) = $85 000.
‡
$100 000 + $50 000 (profit) – $15 000 (cash dividend) + $10 000 (revaluation) – $3000 (deferred tax liability
related to the revaluation).
If Investor accounted for the investment in Investee using the cost method, two items would be
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recognised in the financial statements of Investor for the financial year ended 30 June 20X2:
1. an asset, ‘Investment in Investee’, of $30 000
2. a dividend income of $4500 (30% of $15 000).
In contrast, the focus of the equity method is on the investor’s share of post-acquisition changes in
equity (net assets) of the associate. At 30 June 20X2, Investor’s 30 per cent share of the net assets
of Investee of $142 000 is $42 600 and under the equity method, that is the amount that should be
recognised by the investor in the ‘Investment in Investee’ account. Another way of deriving this amount
is to view the calculation in the following manner:
$
Opening investment 30 000
Add: Share of profit 15 000
Share of other comprehensive income (asset revaluation) 2 100
47 100
Less: Share of dividend received (4 500 )
42 600
The original investment of $30 000 represents Investor’s payment for 30 per cent of the net assets/equity
of Investee at the acquisition date (issued capital $50 000 and retained earnings of $50 000). Changes in
the equity/net assets of Investee since that date are reflected in changes to retained earnings and
reserves (revaluation surplus—other comprehensive income after tax). Therefore, Investor’s share of
these changes is reflected in the equity-accounted amount of its investment in Investee.
Note: All the changes in the investee’s post-acquisition profits, losses and other comprehensive income
are considered after removing the tax effect as only the after-tax changes in those items affect the
investee’s equity.
Example 5.18 illustrates that the underlying principle of the equity method is to measure the
investor’s share of post-acquisition changes in the equity of the associate. Further, changes
to the amount of the equity-accounted investment from the amount originally recognised at
acquisition can be explained through the post-acquisition changes in equity (net assets) in the
associate. The three principal changes are:
1. the profit or loss for the reporting period
2. payment of dividends (which decrease equity/net assets)
3. changes in the investee’s equity that have been included in the investee’s other
comprehensive income (e.g. revaluations in assets from their fair value at acquisition).
You may find it helpful to re-read IAS 28, para. 10 to confirm this discussion. In addition, you may also
wish to read para. 11, which outlines the rationale for implementing the equity method.
Application of the equity method

Basic features
The equity method displays the following basic features:
• the initial investment is brought to account at cost (any goodwill on acquisition is not
separately disclosed as it is included in the cost)
• the investment carrying amount is adjusted for the investor’s share of associate
post‑acquisition profits and losses (to recognise the future economic benefits that may
manifest in dividends paid by the investee to the investor)
• the investor’s share of associate post-acquisition profits and losses is also recognised in
the investor’s profit or loss (as the investor has the power to participate in the associate’s
decision-making, it is considered that they are entitled to a part of the profit obtained by
the associate)
• the investment carrying amount is reduced by all dividends received or receivable from the
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associate (as the economic benefits from the profits of the associate are received)
• the investment carrying amount is also adjusted for the investor’s share of post-acquisition
changes in the associate’s other comprehensive income after tax (which will be reflected in
the equity (net assets) of the associate).
The investor’s share of associate post-acquisition profits and losses is not based on the associate
post-acquisition profits and losses as they are recorded in the associate’s accounts. The recorded
profits and losses are subject to a series of adjustments before they can be allocated to
the investor. These may include adjustments for:
• cumulative preference dividends
• the identifiable assets and liabilities of the associate not recorded at fair value at acquisition
date
• inter-entity transactions between the associate and the investor or any other associate or
subsidiary of the investor.
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Where an associate has cumulative preference shares held by parties other than the investor,
the dividends attached to these shares must be deducted from the profit of the associate for
the year when calculating the investor’s share of associate profits. This applies irrespective of
whether the dividends have been declared by the associate (IAS 28, para. 37). That is because
these dividends will have to be paid eventually from the profits of the associate and therefore
the part of these profits that is related to those dividends will not be available to be allocated to
the investor. For example, let’s assume that A Ltd (A) acquired 30 per cent of the ordinary share
capital of B Ltd (B) and B is considered to be an associate of A. B has cumulative preference
shares (not owned by A) that are entitled to total annual dividends of $10 000. The profit after tax
of B for the year ended 30 June 20X2 was $50 000. In these circumstances, the investor’s share of
investee post-acquisition profits will be $12 000 (i.e. 30% × ($50 000 − $10 000)).
Adjustments to the associate’s profit or loss before it is allocated to the investor may need to
include adjustments for the associate’s identifiable assets that were not recorded at fair value
at acquisition date. That is because the investor’s profit post-acquisition may be overstated/
understated when those identifiable assets are sold or depreciated and the fair value increments/
decrements are realised in full or partially. For example, if the associate had some inventory
undervalued by $10 000 at acquisition date (i.e. its carrying amount was $40 000, while the fair
value is $50 000) that it sold in the period after acquisition for $80 000, the associate’s profit would
include profit from the sale of inventory of $40 000 (i.e. $80 000 − Carrying amount of $40 000).
However, this profit would be overstated from the investor’s perspective as from its point of view
the profit should be $30 000 (i.e. $80 000 − Fair value of $50 000). Therefore, the investor would
need to adjust the associate’s profits for the fair value increment at acquisition date of $10 000
before recognising its share as part of the carrying amount of the investment and its own profits.
Inter-entity transactions involving assets transferred among the investor, its associates or
subsidiaries may generate profits or losses that are recognised in the recorded profits of the
associate or the investor. However, to the extent that those assets are still held at the end of the
period by the entities participating in these transactions, the profits are considered unrealised
from the investor’s perspective, just like the profits from intra-group transactions discussed under
the consolidation procedures. As such, these unrealised profits from inter-entity transactions
should be eliminated from the associate’s profits before allocating them to the investor. IAS 28,
para. 28 specifically deals with this issue and requires both ‘upstream’ (from associate to investor
or its consolidated subsidiaries) and ‘downstream’ (from investor or its consolidated subsidiaries
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to associate) transactions to be eliminated to the extent of the investor’s share of the associate’s
profits or losses.
The principal features of the equity method are reviewed and illustrated shortly by looking at:
• identifying the share of the associate that belongs to the investor
• recognising the initial investment at cost
• recognising the investor’s share of the associate post-acquisition profits and losses
• recognising the dividends provided by the associate
• recognising the investor’s share of the associate post-acquisition other comprehensive income.
If you wish to explore this topic further you may now read IAS 28, paras 33–6, which deal with the
issues that relate to the investor and associate having reporting periods that end on different dates
or different accounting policies.
Note: Consistent with the approach adopted when discussing the preparation of consolidated
financial statements earlier in this module, assume for the purposes of this module that the investor
and associate have consistent accounting policies and that their reporting periods end on the
same date.
Identifying the share of the associate that belongs to the investor

In order to implement the equity method, it is necessary to calculate the investor’s share of a
number of items contained in the financial statements of the associate. The investor’s share of
these items is determined in accordance with the present ownership interest. This ownership
interest needs to be distinguished from the investor’s voting power, which is an important factor
in determining whether significant influence exists, but it is not considered when calculating the
investor’s share of the associate’s post-acquisition equity.
The ownership interest represents the percentage of the associate’s shares held by the investor,
directly or indirectly through its subsidiaries. Therefore, if an investor is a parent in a group,
the ownership interest by that investor should recognise all of the associate’s shares held by any
entity within the group. However, the equity interests held by other associates of the investor
or its subsidiaries are ignored (IAS 28, para. 27). Potential ownership interests arising from
options, or other instruments that are convertible into shares, are not included except under
the special circumstances outlined in para. 13 (IAS 28, para. 12).
Any interests held to obtain a specified distribution, but with no other rights (e.g. non‑participating,
cumulative preference shares), should be excluded from the calculation of ownership interest.
Holders of these interests have no rights to participate in profits in excess of their stated
distribution rate, or in the distribution of associate assets in excess of their contributed capital.
Therefore, they are not deemed to be equivalent to an ownership interest or provide a share of
the profits or net assets of the investee.
➤➤Question 5.21
(a) Refer to the diagram below. The percentages included in the diagram represent the
percentage of shares held. What is the total ownership interest by Investor in Z Ltd (Z),
both direct and indirect?
Investor (W Ltd)
80% 30%
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Subsidiary (X Ltd) Associate (Y Ltd)

5%
25% 10%
Associate (Z Ltd)
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(b) Does the level of ownership interest you have calculated in (a) determine whether or not Z 
is an associate of Investor? Justify your answer.
(c) Will your answer to (b) be different if the percentages included in the diagram also represent
voting power? Justify your answer.
Recognising the initial investment at cost

As indicated in the definition of ‘the equity method’ contained in IAS 28, para. 3, the investment
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in an associate should initially be recognised at cost. This amount is the consideration transferred
by the investor and it may be different from the investor’s share of the fair value of the net assets
of the associate. Similar to the case of business combinations discussed in Part A of this module,
it is possible to calculate the difference between the consideration transferred and the investor’s
share of the fair value of the identifiable net assets of the associate as goodwill (if positive)
or gain on bargain purchase, otherwise known as excess on acquisition (if negative). Note that
gain on bargain purchase is not addressed in this module as it is rarely seen in practice.
Goodwill must be determined on acquisition in accordance with IFRS 3. To determine the

amount of goodwill, the investor first notionally adjusts the net assets of the associate to their
fair value. Any positive difference between the cost of the investment and the investor’s share of
the notionally adjusted fair values is regarded as goodwill.
As goodwill represents the excess of the consideration transferred over the investor’s share of the
fair value of the identifiable net assets of the associate, it is already recognised as part of the cost
in the investment account. After acquisition, goodwill continues to be reflected in the carrying
amount of the investment. Moreover, consistent with IFRS 3, it must not be amortised and, hence,
does not impact on the investor’s share of the associate’s profit (IAS 28, para. 32(a)). The goodwill
included in the carrying amount of the investment is not tested for impairment in its own right.
Instead, the total carrying amount of the investment in the associate is assessed for impairment
in accordance with IAS 36 (IAS 28, para. 42).
If you wish to explore this topic further you may now read IAS 28, paras 32 and 42.
Example 5.19: E
quity method—notional determination
of goodwill
Assume that, on 1 July 20X4, Investor Ltd (Investor) acquired 30 000 ordinary shares in Investee Ltd
(Investee) for $55 000. At that date the equity/net assets of Investee was as follows:
$
Issued capital (100 000 shares issued) 100 000
Net assets 136 000
Investor estimated that, based on fair value, the assets of Investee were undervalued by $20 000; $8000
of this amount related to non-depreciable assets and $12 000 to depreciable assets. Investor used its
influence to have these assets revalued in the accounting records of Investee, which was considered to
be an associate. This revaluation led to an increase in revaluation surplus (via OCI) of $14 000 (increase
in assets of $20 000 less recognition of deferred tax liability of $6000).
Investor would have an asset in its statement of financial position described as ‘Investment in associate,
$55 000’. This would form the initial carrying amount for the same item when using the equity method.
Investor would need to identify whether goodwill had been acquired by comparing the consideration
transferred (i.e. the cost that is originally recognised as the carrying amount of the investment at
acquisition date) with its share of the identifiable net assets of Investee at their fair values as follows:
$
The net assets of Investee at their fair values ($136 000 + $14 000) 150 000
Cost (carrying amount of investment) 55 000

Less: Investor’s share of identifiable net assets (30%† of $150 000) (45 000 )
Goodwill 10 000
†
Purchased 30 000 of the 100 000 ordinary shares issued.

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➤➤Question 5.22
Use the data from Example 5.19 to answer (a) and (b).
(a) Comment on the treatment of the goodwill, both at the time of the investment and in
subsequent accounting periods, under the equity method.
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(b) Investee revalued its assets to their fair value at the acquisition date. What is the effect of this
revaluation on the equity-accounted investment immediately after acquisition (if prepared
at that time) and in subsequent accounting periods?
Recognising the investor’s share of the associate post-acquisition profits and losses
At this stage, ignoring any adjustments that may normally be required (i.e. for preference
dividends, assets undervalued/overvalued at acquisition date or inter-entity transactions),
the following pro forma journal entries would be prepared to equity-account for the investor’s
share of post-acquisition profit of the associate:
1. Share of current post-acquisition profit

Dr Cr
$ $
Investment in associate xx
Share of profit or loss of associates xx

This entry reflects the information that must be recorded in the P&L and OCI in accordance
with IAS 1, para. 82(c). Additional information about the investor’s share of the profit or loss
of associates is required to be disclosed by IFRS 12. Given the closeness of their relationship,
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whereby the investor is able to influence the amount of variable returns that they can obtain from
their investment in the associate, the investor is allowed to recognise its share of the associate’s
profit as increasing the value of its investment, even though that share of the profits is not yet
distributed to the investor via dividends (and may never be).
Remember that this module assumes that the investor prepares consolidated financial statements
and applies the equity method for associates in those financial statements. In addition, it assumes
that the investor accounts for the investment in the associate in its own financial statements
using the cost method. As such, the investment account in the individual accounts of the investor
does not recognise the investor’s share of profits and therefore the entry above is posted on
the consolidation worksheet.
2. Share of previous post-acquisition profits

Dr Cr
$ $
Retained earnings (opening balance) xx
As discussed in Part B of this module, consolidation worksheet entries from previous periods do not
carry over to the current period. Considering that the previous periods’ profits were recognised in
those previous periods in similar journal entries as in list entry 1, to recognise the share of previous
post-acquisition profits in a current period, the investment account is still debited, but the credit
will be recognised against retained earnings (opening balance) as that account should recognise
the investor’s profit that originated from the previous periods’ post-acquisition profits. Also,
it is important to note that the amount recognised in this journal entry represents the investor’s
share of the previous post-acquisition profits of the associate not yet distributed via dividends.
The adjustment for dividends is necessary as the investor is interested in the overall increase in the
associate’s equity, after some equity was distributed via dividends.
Recognising the dividends provided by the associate

As discussed above, dividends represent a decrease in the associate’s equity and under the
equity method the investor should recognise a decrease in the investment account as a result.
This module has assumed that the investor is accounting for the investment in the associate at
cost in its own financial statements. Hence, in the records of the investor, dividend income from
associates would be accounted for as revenue in the following way:
Dr Cr
$ $
Bank/dividend receivable xx
†
Dividend income xx
†
Depending on whether the dividend has been paid or is payable by the associate.
To avoid double counting when applying the equity method, the consolidated financial statements
cannot include as part of the investor’s profit dividend income from the associate (recognised in
the individual account of the investor when applying the cost method, according to the above
journal entry) and the investor’s share of the profit or loss of the associate (which includes that
dividend and was recognised on consolidation, according to consolidation worksheet entries
1 and 2 on post-acquisition profits). Therefore, to apply the equity method in its consolidated
financial statements, the following consolidation worksheet entry would be necessary:
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Dr Cr
$ $
Dividend income xx
Recognising the investor’s share of the associate post-acquisition

other comprehensive income
The associate post-acquisition OCI is normally recognised under reserves. As discussed in
Module 2, OCI will include items of income and expenses that IFRSs require to be recognised
in OCI. Once recognised in OCI, these items of income and expenses are then accumulated in
equity via a reserve (e.g. revaluation surplus).
Therefore, in order to recognise the investor’s share, an examination of the post-acquisition

changes in the reserves is required. Where a change in post-acquisition reserves should be
equity-accounted for by the investor (as it reflects the associate’s OCI post-acquisition) the
following entry is necessary for the investor’s share (in this case assuming an increase in reserves):
Study guide | 453
Dr Cr
$ $
Share of other comprehensive income xx
IAS 1 requires the presentation of any share of the other comprehensive income of associates
(IAS 1, para. 82A).
Note that in order for the change in the reserve to be recognised for the investor, it must
not already be reflected in the carrying amount of the investment. Hence, any transfer to
reserves from the retained earnings account can be ignored and treated as if still part of the
retained earnings. The amount in the retained earnings account transferred out would already
be reflected in the carrying amount of the investment, either via purchase consideration
(pre‑acquisition profits) or as a share of post-acquisition profits.
It is also important to note that the cost of the investor’s investment in the associate (the initial
amount of the equity-accounted investment) takes into account the fair value of the associate’s
assets at the acquisition date. Therefore, the investor should exclude from its share of other
comprehensive income of the associate any changes in the fair value of the associate’s assets
that are included in the initial cost of the investment.
Example 5.20: Application of equity method in consolidated

Example 5.20 is an extension of Example 5.19, where Investor Ltd (Investor) acquired 30 000 ordinary
shares (30%) in Investee Ltd (Investee) on 1 July 20X4. Investor accounts for the investment in the
associate at cost in its financial statements and by the equity method in its consolidated financial
statements.
Assume that during the year ending 30 June 20X5, the following information was available for Investee:
$000
Profit before tax 120
Less: Income tax expense (36 )
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Profit for the year 84
Retained earnings 01 July 20X4 36
120
Dividends paid (50 )
Retained earnings 30 June 20X5 70
The abridged statement of financial position as at 30 June 20X5 of Investee was as follows:
$000
Issued capital 100
Retained earnings 70
Revaluation surplus 14
Liabilities 106
290
Assets 290
290
As Investor accounts for the investment in Investee at cost in its financial statements, it would:
• account for the dividend received ($15 000) as dividend income
• not process an entry for its share of the profits of Investee.
The financial statements of Investor included the following information:
Investor
$000
Profit before tax† 315
Profit for the year 225
Retained earnings 01 July 20X4 100
325
Dividends paid (140 )
Retained earnings 30 June 20X5 185
†
Includes dividend income from Investee of $15 000. Note that no tax is payable on the dividend income for
the purposes of this example.
The abridged statement of financial position of Investor as at 30 June 20X5 was as follows:
$000
Issued capital 600
Retained earnings 185
Liabilities 270
1 115
Investment in Investee 55
Other assets 1 060
1 115
The following consolidation worksheet would be prepared by Investor to equity-account for its
investment in Investee. (Note: The financial statements of subsidiaries and their related consolidation
elimination entries have been ignored to focus on the effect of the equity adjustment entries.)
Elimination Consolidated
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adjustments financial
Investor Dr Cr statements
Accounts $000 $000 $000 $000
Dividend income 15 15† —
Other items of revenue and 300 300
expense in determining profit
Share of profits or loss of associates 25.2‡ 25.2
Profit before tax 315 325.2
Profit for the year 225 235.2
Retained earnings 01.07.X4 100 100
325 335.2
Less: Dividends paid (140) (140)
Retained earnings 30.06.X5 185 195.2
Liabilities 270 270
1 115 1 125.2
Investment in Investee 55 25.2‡ 15† 65.2
Other assets 1 060 1 060
1 115 1 125.2
Notes: Adjusting entries
†
Elimination of dividends paid by Investee.
‡
Share of after-tax profit of associate (30% of $84 000).
Study guide | 455
The equity-accounted amount of the investment can be reconciled as follows:
$
The net assets of Investee ($100 000 + $70 000 + $14 000) 184 000

Investor’s share of net assets of Investee (30% of $184 000) 55 200
Add: Goodwill 10 000
Carrying amount of investment 65 200

Alternatively:
$
Investor’s original investment 55 000
Add: Share of profit 25 200
80 200
Less: Share of dividends paid (15 000 )
Carrying amount of the investment 65 200
If you wish to explore this topic further you may now read IAS 1, para. 82.
➤➤Question 5.23
Using the information in Example 5.20, prepare financial statements for Investor that comply
with the disclosure requirements of IAS 1.
Transactions between associate and investor (or its subsidiaries)

Part B of this module discussed the requirement of IFRS 10 to eliminate in full unrealised profits
or losses on transactions between members of the group. As already discussed in this part
(Part C) of the module and confirmed in IAS 28, para. 26, many of the procedures appropriate
for the equity method are similar to consolidation procedures. To be consistent, transactions
between the associate and investor (including its consolidated subsidiaries) should be eliminated.
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This is reinforced by IAS 28, para. 28, which requires that where an associate is equity-accounted
for, unrealised profits and losses from both ‘upstream’ and ‘downstream’ transactions between
the investor (or its consolidated subsidiaries) and associate should be eliminated to the extent
of the investor’s ownership interest in the associate.
If you wish to explore this topic further you may now read IAS 28, paras 26 and 28.
Note: This module does not deal with transactions between associates in a group.
In relation to transactions between the associate and the investor (or its
consolidated subsidiaries), the following approach is adopted:
• only transactions involving unrealised profits and losses require elimination, taking into
consideration the related tax effect
• the elimination is in proportion to the investor’s ownership interest in the associate
• the elimination adjustments are only calculation adjustments with the result being recorded
against two accounts—‘investment in associates’ and ‘share of profits of associates’.
Example 5.21: Transactions between investor and associate

Using the data from Example 5.20, assume that the following additional events/transactions took place
during the year ended 30 June 20X5:
• Investee Ltd (Investee) revalued land upwards by $20 000, net of tax effect (this revaluation was
not reflected in Investor’s cost of acquisition)
• Investor Ltd (Investor) sold $15 000 (original cost $5000) of inventory to Investee—all inventory is
still on hand at 30 June 20X5.
Assuming, for illustrative purposes, that the tax rate is 30 per cent, the following consolidation worksheet
would be prepared:
Elimination Consolidated
adjustments financial
Investor Dr Cr statements
Accounts $000 $000 $000 $000
Dividend income 15 15† —
Other items of revenue and 300 300
expense in determining profit
Share of profits or loss 2.1‡ 25.2§ 23.1
of associates
Profit before tax 315 323.1
Profit for the year 225 233.1
Retained earnings 01.07.X4 100 100
325 333.1
Less: Dividends paid (140) (140)
Retained earnings 30.06.X5 185 193.1
Revaluation surplus 60 6|| 66
Liabilities 270 270
1 115 1 129.1
Investment in Investee 55 25.2§ 15†
6§ 2.1‡ 69.1
Other assets 1 060 1 060
1 115 48.3 48.3 1 129.1
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Notes: Adjusting entries

†
Elimination of dividends paid by Investee.
‡
Elimination of unrealised profit on inventory on a net basis. That is, the only accounts affected are
‘Investment in Investee’ and ‘Share of profit or loss of associates’. The elimination reflects the investor’s
ownership interest (30%) in the unrealised profit after tax of $7000 (($10 000 × (1 –.30)).
§
Share of profit of associate.
||
Investor’s share of the revaluation of land by Investee. The increase in the revaluation reserve would be
recognised in the P&L and OCI as OCI.
Note: The elimination is not against the individual accounts affected as would be the case with a consolidation
adjustment for unrealised profits or losses.

Study guide | 457
➤➤Question 5.24
(a) Using the information in Example 5.21, prepare a single consolidated P&L and OCI for Investor
in accordance with IAS 1, paras 10A and 82.
(b) What difference would it make if the inventory was sold from Investee to Investor?
(c) Reconcile the equity-accounted investment in Investee of $69 100 to Investor’s share of the
net assets shown in the statement of financial position of Investee.
Investor’s share of losses

In preceding examples and questions, the associate has earned a profit. Where the associate
incurs a loss, application of the equity method requires a reduction in the equity-accounted
amount of the investor’s investment and recognition of the investor’s share of the associate’s loss.
Losses recognised under the equity method are applied first to the investment in ordinary
shares and, if this is exceeded, the losses are then applied to the other components (long-term
receivables, loans, preference shares) of the investor’s interest in the associate in reverse order of
priority in liquidation (IAS 28, para. 38). Therefore, the investor’s entry to recognise losses would
be as follows:
Dr Cr
$ $
Share of profits or losses of associates xx
Investment in ordinary shares/preference shares xx
Where the share of the associate’s losses exceeds the investor’s interest (carrying amount of
investment in associate, preference shares and long-term receivables or loans), the investor
discontinues recognising those losses (IAS 28, para. 38). Therefore, the equity method would
cease and the investment would be recorded at zero. Additional losses would only be provided
for (a liability recognised) where the investor has an obligation to make payments on behalf of
the associate (IAS 28, para. 39). Moreover, when application of the equity method recommences,
the investor’s share of associate profits can only be recognised after offsetting the investor’s share
of losses not previously recognised (IAS 28, para. 39).
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If you wish to explore this topic further you may now read IAS 28, paras 38 and 39. In addition,
you may also wish to read:
• IAS 28, paras 22–4, which discuss the discontinuation of the equity method where the investee
ceases to be an associate
• IFRS 12, para. 22(c), which relates to the disclosure of unrecognised losses.

➤➤Question 5.25
On 1 July 20X6, the consolidated financial statements of Investor contained an asset, ‘Investment
in associate’, of $30 000. For the financial year ended 30 June 20X7 the associate incurred a
loss of $150 000, while for the 20X8 financial year it earned a profit of $80 000. Investor owns
30 per cent of the issued capital of the associate.
Ignoring income tax effects, prepare consolidation worksheet entries for the 20X7 and 20X8
financial years to equity-account for Investor’s share of profits and losses. Determine the amount
of the investment in the associate as at 30 June 20X7 and 30 June 20X8.
Dr Cr
30 June 20X7 $ $
Dr Cr
30 June 20X8 $ $
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Disclosures for associates

IAS 1 requires the following line items to be separately presented in the financial statements of
investors with associates:
• in the statement of financial position—‘investments accounted for using the equity method’
(IAS 1, para. 54(e))
• in the P&L—‘share of the profit or loss of associates and joint ventures accounted for using
the equity method’ (IAS 1, para. 82(c))
• in OCI—line item for each item of OCI ‘including share of the other comprehensive income
of associates and joint ventures accounted for using the equity method’ (IAS 1, para. 82A).
In addition to the disclosures required by IAS 1, IFRS 12 requires entities to disclose information
about interests in joint arrangements and associates. As discussed in Section B, the objective
of IFRS 12 is to help financial statement users to assess:
• the nature of, and risks involved with, an entity’s interests in other entities
• the effects of those interests on the entity’s financial position, financial performance and cash
flows (IFRS 12, para. 1).
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To satisfy the objective of IFRS 12, entities need to disclose:

• significant judgments and assumptions made in determining that the entity has significant
influence over another entity (IFRS 12, para. 7(b))
• financial and other information for entities that are determined to be associates (IFRS 12,
para. 20).
IFRS 12, para. 20 requires entities with interests in associates to disclose information that
focuses on:
• the nature, extent and financial effects of its interests in associates including contractual
arrangements with other investors in the associates (IFRS 12, paras 20(a), 21 and 22)
• the nature of, and changes in, the risks related to interests in associates (IFRS 12,
paras 20(b) and 23).
IFRS 12, paras 21 to 23 contain extensive disclosure requirements that include information such as:
• details of each material associate (name, nature of its relationship with the entity, principal
place of business, proportion of ownership interest held by the entity)
• financial information for material associates (whether investment in the associate is measured
using equity method or fair value, summarised financial information)
• nature and extent of any significant restrictions on the associate paying dividend to entity or
repaying loans and advances
• unrecognised share of losses if the entity has ceased to apply the equity method
• contingent liabilities incurred in relation to associates.
If you wish to explore this topic further you may now read IFRS 12, paras 1, 7–9, and 20−3.
Summary
IAS 28 deals with the measurement and presentation of information concerning investments in
associated entities. IAS 28 prescribes that an investment in an associate should be accounted
for using the equity method of accounting. In essence, applying the equity method results
in the investment being recorded at the investor’s share of the associate’s net assets.
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Both IAS 1 and IFRS 12 prescribe disclosures for investments in associates. These disclosures
include:
• the investor’s share of profits or losses and share of other comprehensive income
from associates
• carrying amount of investments in associates
• significant judgments and assumptions made in determining that the entity has significant
influence over another entity
• extensive disclosure for material associates, including summarised financial information
for these associates.
Part D: Joint arrangements—overview

Having discussed accounting for interests in subsidiaries (Part B) and interests in associates
(Part C), this module concludes by providing a brief overview of accounting for interests
in joint arrangements. In May 2011, the IASB, in addition to issuing IFRS 10, also replaced
IAS 31 Interests in Joint Ventures with IFRS 11.
A joint arrangement is defined by IFRS 11 as an ‘arrangement of which two or more parties have
joint control’ (IFRS 11, para. 4). There are two essential characteristics of a joint arrangement:
• the parties to the arrangement must be bound by a contractual agreement in relation to
the terms on which the parties participate in the activities of the arrangement
• the contractual agreement gives rise to two or more parties having joint control of the
arrangement (IFRS 11, para. 5).
Consistent with the principle of control in IFRS 10 (discussed in Part B of this module),
joint control only arises when decisions relating to the relevant activities of the arrangement
require the unanimous consent of the parties who share control (IFRS 11, para. B6). The need
for unanimous consent makes joint control weaker than the control that may establish a parent−
subsidiary relationship where the parent has full control over the subsidiary. This is because
a parent is able to exercise control of a subsidiary unilaterally without being dependent on
obtaining the consent of other parties, which is necessary in a joint arrangement. Joint control,
however, is considered to establish a stronger relationship than that resulted from significant
influence, as the parties to a joint arrangement control (albeit jointly) decisions made in relation
to the joint arrangement, while an investor can only participate in decisions in relation to
the investee.
Joint arrangements are quite common in the mining and real estate industries, where such an
arrangement is preferable to operating individually or to large scale acquisitions that may be
difficult to fund due to limited capital and debt finance. Joint arrangements allow sharing the
risks related to capital investment and other project risks. For example, in the mining industry the
risks of underperformance and even bankruptcy are very high due to a relatively low probability
of finding economically recoverable resources. Mining companies need financial resources to
secure future production via investments in their exploration activities and development of
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mining sites in situations where revenue is yet to be generated. It is extremely difficult for them
to get access to those resources from lenders. Establishing a joint arrangement where two or
more such entities ‘share the load’—by contributing assets, expertise/specialised knowledge or
other resources with a view to sharing the output—may be extremely beneficial, even though
it comes with its own set of problems, including a potential withdrawal of one party after the
agreement has been signed (e.g. on 11 June 2015, Australian Mines Ltd entered into a joint
venture agreement with Lodestar Minerals Ltd, only to withdraw on 21 December 2015 due to
failure to find significant base metal deposits in the tenements at Ned’s Creek that comprised
the joint venture). The characteristics of joint control may also result in a joint arrangement
that is difficult to manage as there may be uncertainty about who makes the major decisions.
Nevertheless, there are some success stories.
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Example 5.22: Examples of successful joint arrangements

The Gippsland Basin joint venture was established on 28 May 1964 when Esso Australia Resources
Pty Ltd (Esso), a subsidiary of ExxonMobil, and BHP Billiton Petroleum (Bass Strait) Pty Ltd, a subsidiary
of BHP Billiton, signed an agreement for oil and gas exploration off Victoria’s Gippsland coast and the
agreement is still ongoing; as of 2014, the Gippsland Basin joint venture was meeting nearly 40 per cent
of the east coast Australian domestic gas demand (Gas Today 2014).
While the parties have recently been looking at selling the joint venture’s declining oilfields, the joint
arrangement still holds substantial gas reserves to keep it going (Macdonald-Smith 2016).
A similar success story is represented by the Channar Mining joint venture in the Western Australia’s
Pilbara region established in 1987 between Rio Tinto and Sinosteel Corporation Ltd, with the agreement
extended on 15 April 2016 to 2021 (Rio Tinto 2016).
Once it has been determined that the entity has an interest in a joint arrangement, IFRS 11
requires the joint arrangement to be classified as either a ‘joint operation’ or a ‘joint venture’
(IFRS 11, para. 14). A joint arrangement is deemed a joint venture if the parties that have joint
control have rights to the net assets of the arrangement (IFRS 11, para. 16). An arrangement is
considered a joint operation when the parties that have joint control have rights to the assets of,
and obligations for the liabilities of, the arrangement (IFRS 11, para. 15).
The accounting treatment of those two forms will be different. As a joint operation involves
an arrangement where the joint operators have a right to the assets of, and obligation for the
liabilities of, the joint arrangement, IFRS 11 requires the joint operator to recognise individually
its share of the assets, liabilities, revenues and expenses that arise from its interest in the joint
operation (IFRS 11, paras 20 and 21). These items will be accounted for in accordance with
relevant IFRSs. As a joint venture involves the joint venturers having an interest in the net
assets of the arrangement, IFRS 11 requires the joint venturer to recognise its interest in the
arrangement as an investment to be accounted for using the equity method in accordance with
IAS 28 (para. 24). The equity method was discussed in Part C of this module.
As indicated by the preceding discussion, the classification of whether a joint arrangement is

a joint operation or joint venture depends on an assessment of the rights and obligations that
arise from the entity’s involvement in the arrangement. Therefore, an assessment of the rights
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and obligations of individual parties to the arrangement to capture the economic substance of
the arrangement helps ensure consistency in accounting and therefore enhanced comparability
of financial statements.
This assessment involves professional judgment, and IFRS 11, para. 17 requires the entity to
consider factors such as:
• the legal form of the arrangement
• the terms agreed in the contractual arrangement
• other facts and circumstances when relevant.
Finally, it should be noted that the disclosure requirements of IFRS 12, discussed in Part C
in relation to associates, also apply to joint arrangements.
If you wish to explore this topic further you may now read IFRS 11, paras 4–25.
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Appendix 5.1 | 463
Appendix
Appendix
Appendix 5.1
Case study 5.1
1. On 1 July 20X0, Parent Ltd (Parent) purchased all the shares of Subsidiary Ltd (Subsidiary)
for $230 000.
2. At the acquisition date, the equity section of Subsidiary contained the following accounts:
$
180 000
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3. Parent considered that the plant owned by Subsidiary had a fair value of $80 000. An extract
from the financial statements of Subsidiary revealed the following:
$ $
Plant (at cost) 100 000
4. Subsidiary estimated the remaining useful life of the plant to be five years with a scrap value
of $0 at the end of this time. Subsidiary used the straight-line depreciation method for this
type of plant.
5. Assume the plant was sold on 1 July 20X2 for $40 000 to an external party.
6. Assume that the provisions of IAS 12 in relation to the revaluation of assets in a business
combination are applied. The tax rate is 30 per cent.
Case study 5.2

On 1 June 20X3, a parent entity sold inventory to a subsidiary for $40 000. The cost of the
inventory to the parent was $30 000. Assume a tax rate of 30 per cent. The inventory was still on
hand at the end of the financial year 30 June 20X3.
Assumptions:
1. All of the inventory held by the subsidiary as at 30 June 20X3 was sold to parties external
to the group in July 20X3 for $50 000.
2. Half of the inventory held by the subsidiary as at 30 June 20X3 was sold to parties external to
the group by 30 June 20X4 for $25 000. The rest was sold to external parties by 30 June 20X5.
Case study 5.3

Parent Ltd (Parent) owns 70 per cent of the issued capital of Subsidiary Ltd (Subsidiary).
During the year ended 30 June 20X4:
• Subsidiary sold inventory to Parent at a profit of $40 000 (the inventory was still on hand at
30 June 20X4)
• Parent sold plant to Subsidiary for $50 000 at a profit of $10 000 (the plant was still on hand
at 30 June 20X4)
• Subsidiary provided Parent with management services for which it charged $30 000.
The plant was sold by Parent to Subsidiary on 1 July 20X3 and was depreciated on a straight‑line
basis. The plant had a useful life of five years with a scrap value of $0 at the end of that period.
The following items were extracted from the consolidation worksheet for the year ended
30 June 20X4:
Parent Subsidiary
$ $
Add: Opening retained earnings 60 000 40 000
460 000 240 000
Less: Dividends paid (180 000 ) (100 000 )
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Closing retained earnings 280 000 140 000
Assume a tax rate of 30 per cent.

Assume that all of the inventory purchased by Parent from Subsidiary in the year ended 30 June
20X4 was sold to parties external to the group during the financial year ended on 30 June 20X5.
Moreover, assume that the following items were extracted from the consolidation worksheet for the
year ended 30 June 20X5:
Parent Subsidiary
$ $
Add: Opening retained earnings 280 000 140 000
630 000 240 000
Less: Dividends paid (150 000 ) (50 000 )
Closing retained earnings 480 000 190 000
Appendix 5.1 | 465
Case study 5.4

On 1 July 20X0, Parent Ltd (Parent) purchased 70 per cent of the issued capital of Subsidiary Ltd
(Subsidiary) for $120 000. An extract from the equity section of the statement of financial position
of Subsidiary at the acquisition date revealed the following:
$
150 000
At the acquisition date, the identifiable net assets of Subsidiary were recorded at fair value.
The following events were relevant in preparing the consolidated financial statements for the
• During the financial year ending 30 June 20X1, Parent sold inventory that had cost $5000
to Subsidiary for $9000. The inventory was still on hand as at 30 June 20X1.
• Over the financial year ending 30 June 20X1, Parent charged Subsidiary $3000 for services
rendered. The services were not paid for by the end of the financial year.
• On 30 June 20X1, Subsidiary sold plant to Parent for $16 000 at a loss of $4000. The plant
had a remaining useful life of two years with a residual value of $2000.
• On 30 June 20X1, Subsidiary declared a final dividend of $10 000. Parent recognised
dividend income when it became receivable.
• A tax rate of 30 per cent is assumed.
• Assume that the dividends paid by Subsidiary to Parent were tax free.
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Assumed knowledge
review
Assumed knowledge review
Assumed knowledge review questions

Question 1
On 1 March 20X3, Holding Ltd (Holding) signed an agreement with the shareholders of
Subsidiary Ltd (Subsidiary) to acquire the entire issued capital (12 000 shares) of that company.
Holding agreed to issue five Holding shares for every two Subsidiary shares. Subsidiary was to
continue to operate its business as a subsidiary of Holding.
The terms of the agreement were fulfilled on 30 June 20X3, when the share transfer took place.
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Immediately prior to settlement, the statements of financial position for the companies were
as follows:
Holding Subsidiary
$000 $000
Liabilities 50 25
270 120
270 120
At 30 June 20X3, it was determined that the fair values and the tax bases of the net assets
of Subsidiary were:
Fair value Tax base
$000 $000
Liabilities (25 ) (25 )
125 95
At 30 June 20X3, the shares issued by Holding to the shareholders of Subsidiary traded on
the securities exchange at $5.00 per share.
Prepare a consolidation worksheet, assuming that at acquisition date Subsidiary had:

(a) revalued its non-current assets to their fair value in its own financial records
(b) used a consolidation adjustment to revalue the assets to their fair values.
Question 2
(a) On 15 June 20X3, a subsidiary sold inventory to its parent for $20 000. The cost of the
inventory to the subsidiary was $10 000. Ignore tax effects.
(i) Prepare a consolidation elimination entry for the year ended 30 June 20X3, assuming that
all inventory was on hand with the parent at the end of the financial year.
(ii) Prepare a consolidation elimination entry for the year ended 30 June 20X3, assuming that
half of the inventory was sold by the parent during the year for $16 000.
(iii) Using the information in (ii), prepare a consolidation elimination entry for the financial
year ending 30 June 20X4. Assume that all the remaining intra-group inventory was sold
to external parties for $16 000 by 30 June 20X4.
(b) During the year ended 30 June 20X5, a parent entity provided management services to its
subsidiary for $25 000. At 30 June 20X5, the subsidiary still owed the parent entity for $5000
of these services. Prepare a consolidation elimination entry for the year ended 30 June 20X5.
(c) On 30 June 20X7, a wholly owned subsidiary of a parent declared a dividend of $10 000.
The parent entity recognises dividend income on an accrual basis. Prepare a consolidation
elimination entry for the year ended 30 June 20X7.
Assumed knowledge review answers

Question 1
(a) Consolidation worksheet 30 June 20X3 ($000)
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Elimination
adjustments
Issued capital 230† 12 12 230
Retained earnings 140 83 83 140
Revaluation surplus 21 21 —
420 150 454
Current assets 40 30 70
Investment in Subsidiary 150 150 —
Non-current assets 230 120 350
Goodwill 34‡ 34
420 150 150 150 454
†
Original issued capital ($80 000) plus shares issued at fair value to the shareholders of Subsidiary
(30 000 @ $5.00 per share = $150 000).
‡
Consideration transferred ($150 000) minus the fair value of identifiable net assets calculated based
on the value of equity after revaluation ($12 000 + $83 000 + $21 000).
Holding has acquired a single asset, ‘Investment in Subsidiary’, for $150 000. On the other
hand, the group has acquired the business of Subsidiary and this has two implications. First,
the consolidated financial statements of the group must recognise the identifiable assets and
liabilities relating to the combination at their fair values. Second, any goodwill arising from
the business combination must be recognised in the consolidated financial statements.
The assets of Subsidiary were revalued to fair value in Subsidiary’s financial statements
(Non‑current assets increased by $30 000, a deferred tax liability of $9000 was recognised
and the revaluation surplus increased by $21 000).
The worksheet illustrates that:

• the acquirer, Holding, includes its interest in the acquiree in its own financial statements
as an asset called ‘Investment in Subsidiary’
• the identifiable net assets of the subsidiary are recorded at their individual fair values
(see non-current assets = $90 000 + $30 000 revaluation increment)
• a deferred tax liability is recognised due to a temporary difference arising on the revaluation
of the non-current assets
• goodwill has been determined and brought to account in accordance with IFRS 3
• on acquisition of a subsidiary, goodwill has been treated as a consolidated adjustment as
it is the group that has acquired the business of the subsidiary.
(b) Consolidation worksheet 30 June 20X3 ($000s)

Elimination
adjustments
Issued capital 230 12 12† 230
Retained earnings 140 83 83† 140
Business combination reserve 21† 21‡ —
Deferred tax liability 9‡ 9
420 120 454
Current assets 40 30 70
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Investment in Subsidiary 150 150† —
Non-current assets 230 90 30‡ 350
Goodwill 34† 34
420 120 180 180 454
Entries:
†
Pre-acquisition elimination entry.
‡
Revaluation of non-current assets including tax effects.
Note: These entries could have been combined.
In this part of the question, because Subsidiary has not revalued the non-current assets in its
own accounts, the undervalued assets must be revalued via the consolidation process. Hence,
the consolidation elimination entries include a debit of $30 000 to the ‘Non‑current assets’, a credit
of $9000 to a ‘Deferred tax liability’ and a credit of $21 000 to a ‘Business combination reserve’.
Note: Compare this worksheet with that prepared under (a) and note the difference in the
consolidation elimination entry (and in the amount recognised by the subsidiary at acquisition
date). However, as would be expected, note that the resulting consolidated financial statements
are identical.
Question 2
(a) (i) The entry processed by the subsidiary for the sale of inventory to the parent would be
as follows:
Dr Cr
$ $
Bank/trade receivables 20 000
Sales 20 000
Inventory 10 000
The entry processed by the parent for the purchase of the inventory would be as follows:
Dr Cr
$ $
Inventory 20 000
Bank/trade payables 20 000
After these entries in the financial statements of the parent and the subsidiary, the impact
on the consolidation worksheet would be as follows:

Elimination
adjustments
Accounts $000 $000 $000 $000 $000
Sales 20
Less: Cost of goods sold (10)
Gross profit 10
Inventory 20
From the group’s perspective, the sale should not be recognised as it is not to a party
external to the group and, hence, its effects should be eliminated in full. This involves the
following adjustments:
the sales revenue is eliminated as it wasn’t earned as a result of a transaction with
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||
an external party
|| the associated cost of goods sold is also eliminated and, as a consequence of this in
combination with eliminating the sales revenue as discussed above, it results in the
elimination of the profit from the transaction as it is considered unrealised
|| the inventory is adjusted to the original cost to the group ($10 000) from the $20 000
recorded in the statement of financial position of the parent.
Hence, the 20X3 consolidation adjustment entry would be as follows:
Dr Cr
$ $
Sales 20 000
Inventory 10 000
After the consolidation elimination entry, the consolidation worksheet would be as follows:
Elimination
adjustments
Accounts $000 $000 $000 $000 $000
Sales 20 20 —
Less: Cost of goods sold (10) 10 —
Gross profit 10 —
Inventory 20 10 10
(ii) The subsidiary would process the same entry as in Part (i). As the parent sold half of the
inventory for $16 000, the following entries would be processed by the parent for the
purchase of the inventory from the subsidiary and its subsequent sale:
Dr Cr
$ $
Inventory 20 000
Bank/trade payables 20 000

Inventory 10 000
Sales 16 000
The impact on the consolidation worksheet of the intra-group transaction and the
subsequent sale of half the inventory to parties external to the group would be as follows:

Elimination
adjustments
Accounts $000 $000 $000 $000 $000
Sales 16 20
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Less: Cost of goods sold (10) (10)
Gross profit 6 10
Inventory 10
From the group’s perspective, the sale recorded by the subsidiary is not to a party
external to the group and, hence, its effects should be eliminated. That involves the
following adjustments:
|| the sales revenue recorded by the subsidiary ($20 000) is eliminated as it wasn’t
earned as a result of a transaction with an external party
|| the cost of goods sold recorded by the subsidiary ($10 000) must be eliminated
because it relates to an intra-group sale, and the cost of goods sold recorded by
the parent needs to decrease by $5000, as it should reflect half of the original cost
of the inventory to the group (50% of $10 000); as a consequence, the consolidated
cost of goods sold decreases by $15 000 ($10 000 + $5000) and, given that the
consolidated sales revenue decreases by $20 000 as a result of the adjustment
discussed above, this will result in the elimination from the consolidated profit of the
remaining unrealised profit from the intra-group sale of inventory (i.e. the intra-group
profit attributable to the inventory that was not transferred to an external party)
|| the inventory still on hand should be adjusted so that it is recorded at cost to the
group, which is $5000 (50% of $10 000), not the $10 000 recorded in the statement of
financial position of the parent.
Hence, the consolidation elimination entry would be as follows:
Dr Cr
$ $
Sales 20 000
Inventory 5 000
The impact on the consolidation worksheet after the elimination entry is illustrated below:

Elimination
adjustments
Accounts $000 $000 $000 $000 $000
Sales 16 20 20 16
Less: Cost of goods sold (10) (10) 15 (5)
Inventory 10 5 5
It should be noted that the profit of the group is $5000 less than the profit of the parent
plus the subsidiary as it excludes the remaining unrealised profit on the intra-group sale
of inventory from the subsidiary to the parent.
(iii) As the other half of the inventory is sold during the year ended 30 June 20X4 for $16 000,
the following entry would be processed by the parent:
Dr Dr
$ $
Inventory 10 000
Sales 16 000
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The consolidation worksheet prepared at 30 June 20X4 would initially include the following
effects from both internal and external transactions recognised by the individual entities:
Elimination
adjustments
Accounts $000 $000 $000 $000 $000
Sales 16
Less: Cost of goods sold (10)
Gross profit 6
Opening retained earnings† 6 10
Inventory —

†
The balances of the opening retained earnings are equal to the profits recognised in
the year ended 30 June 20X3 by the two entities and includes unrealised profit from the
intra‑group transaction.
From the group’s perspective, the following information should be reflected in the
consolidated financial statements:
|| The sales revenue recognised by the parent is earned from a transaction with an
external party and should be included as revenue of the group.
|| The cost of goods sold should be recorded at the cost to the group of the inventory
sold during the current period to an external party (50% of $10 000 = $5000);
therefore, the cost of goods sold has to decrease by $5000 (from $10 000 as
recognised by the parent); given that sales revenue is not adjusted, the result is that
group profit increases by $5000, essentially recognising that the unrealised profit
attributable to the inventory still on hand at the beginning of the period is realised
during the period as that inventory gets sold to an external party.
|| The opening retained earnings of the group should reflect only profits recognised by
the group as of 30 June 20X3 and, hence, should be equal to the aggregated amount
of opening retained earnings of the parent and subsidiary, minus the unrealised profit
as of 30 June 20X3.
Therefore, the consolidation elimination entry would be as follows:
Dr Cr
$ $
Elimination
adjustments
Accounts $000 $000 $000 $000 $000
Sales 16 16
Less: Cost of goods sold (10) 5 (5)
Gross profit 6 11
Opening retained earnings† 6 10 5 11
Closing retained earnings 12 10 22
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Inventory —
†
The balances of the opening retained earnings are equal to the profits recognised in the year
ended 30 June 20X3 by the two entities and includes unrealised profit from the intra-group
transaction.
The group has recognised $5000 of the previously unrealised profit. It should also be
noted that, by 30 June 20X4, the closing retained earnings of the group ($22 000) is the
same as the profit of the parent plus the subsidiary ($12 000 + $10 000) because all of
the profit has been realised by the group.
(b) The entry processed by the parent for the provision of management services to the subsidiary
would be as follows:
Dr Cr
$ $
Bank 20 000
Revenue from services 25 000
The subsidiary would process the following entry for the receipt of management services
from the parent:
Dr Cr
$ $
Management services expense 25 000
Bank 20 000
The impact on the consolidation worksheet of the intra-group transaction would be as follows:
Elimination
adjustments
Accounts $000 $000 $000 $000 $000
Revenue from services 25
Management services (25)
expense
Trade receivables 5
Trade payables 5
From the group’s perspective, the management services revenue and expense should be
eliminated because they result from an intra-group transaction. Likewise, the group cannot
have a debt to itself and, hence, the intra-group receivable/payable should be eliminated.
Therefore, the intra-group services transaction would result in the following consolidation
elimination entry:
Dr Cr
$ $
Management services revenue 25 000
Management services expense 25 000
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Elimination
adjustments
Accounts $000 $000 $000 $000 $000
Revenue from services 25 25 —
Management services (25) 25 —
expense
Trade receivables 5 5 —
Trade payables 5 5 —
(c) The subsidiary would have processed the following entry to account for the declaration
of the dividend:
Note: Please revise how to account for dividends if necessary. This is assumed knowledge
for this segment.
Dr Cr
$ $
Dividend declared 10 000
The parent would have processed the following entry to account for the final dividend
declared by subsidiary:
Dr Cr
$ $
The impact on the consolidation worksheet of the intra-group transaction would be as follows:
Elimination
adjustments
Accounts $000 $000 $000 $000 $000
Dividend income 10
Dividend declared (10)
Final dividend receivable 10
Final dividend payable 10
From the group’s perspective, there should be no recognition of the dividend declared,
as this is an intra-group transaction. Likewise, the group cannot have a debt to
itself and, hence, the intra-group dividend receivable/payable should be eliminated.
The intra‑group dividend would result in the following consolidation adjustment entry:
Dr Cr
$ $
Dividend declared 10 000
Final dividend receivable 10 000
Elimination
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adjustments
Accounts $000 $000 $000 $000 $000
Dividend income 10 10 —
Dividend declared (10) 10 —
Final dividend receivable 10 10 —
Final dividend payable 10 10 —
Note: If you are unsure of any of the answers, please use the Learning Task to review the concepts
involved and for further practice.
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Suggested answers
Suggested answers
Question 5.1
Only situations (d) and (e) represent business combinations. Situations (a) and (b) represent
acquisition of individual assets that do not constitute a business. The regularity of those kind of
asset acquisitions has no impact on this assessment. The asset acquisitions on a regular basis
may indicate strong relationships between the parties involved, but that does not necessarily
indicate that one entity has control over the other.
Situation (c) describes the acquisition of a bundle of assets that will not be used together to
generate output; as such, this bundle does not satisfy the definition of a business and therefore
the acquisition cannot be recognised as a business combination. Situation (d), on the other hand,
describes a business combination, as the bundle of assets acquired represents a business.
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Situation (e) is again a business combination, but the form is different from situation (d). While
situation (d) describes a direct acquisition, situation (e) represents an indirect acquisition. In both
these cases, the form of the transaction does not matter; it is the substance of acquiring control
of other businesses that makes them business combinations.
Question 5.2
(a) A Ltd would be the acquirer in this combination. This conclusion is supported as follows:
–– With 90 per cent of the voting rights, A Ltd would have the power over the investee
to affect the amount of the returns it would receive from B Ltd as the holders of the
other 10 per cent of the voting rights would not have the ability to out-vote A Ltd when
decisions about relevant activities of B Ltd need to be made.
–– A Ltd would be able to appoint the directors of B Ltd, who could direct the activities
of the company to provide a return to A Ltd via its performance.
–– A Ltd provided consideration as it gave up cash to acquire the ordinary shares of B Ltd
(IFRS 3, para. B14).
(b) D Ltd was formed to facilitate the business combination and issued shares in D Ltd for all of
the shares in A Ltd, B Ltd and C Ltd to their former owners/shareholders. In such situations,
one of the combining entities that existed before the combination is identified as the acquirer.
One must determine whether A Ltd, B Ltd or C Ltd is exposed, or has the rights, to variable
returns from its involvement with the other entities and has the ability to affect those returns
through its power over the entities, that is, which entity has control over the other entities in
the combination.
In some circumstances, this may be an arbitrary decision. It is essential to focus on the

substance and not the form of the transaction. IFRS 3 indicates that it is important to consider
factors such as which entity initiated the combination, the relative size of the combining entities
(IFRS 3, para. B17) and those indicators listed in IFRS 3, para. B15. For example, the acquirer
is likely to be the entity that has a significantly greater fair value than the other entities, or
the entity that has a management that will dominate the selection of the combining entity’s
management. Without further information about the combining entities, it is difficult to
nominate which one would be the acquirer.
(c) Even though A Ltd acquired the shares of B Ltd, the combination could be a reverse acquisition
where B Ltd is in fact the acquirer. After the combination, the original shareholders of B Ltd will
hold 800 000 shares in the combined entity (via shares in A Ltd), while the original shareholders
in A Ltd will hold only 500 000 shares in the combined entity. Hence, the original shareholders
in B Ltd may now be able to replace (or appoint the majority of) the directors of A Ltd. In such
circumstances, B Ltd would have the rights to variable returns from A Ltd (via dividends) and
the ability to affect those returns through its power over A Ltd (IFRS 10, para. 6). Hence, B Ltd
would be considered to be the acquirer in the combination. As with all combinations, all of the
circumstances involved would have to be considered.
Question 5.3
Goodwill represents the future economic benefits from unidentifiable assets. Identifiable assets are
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those assets capable of being individually identified and recognised in the financial statements.
IAS 38 defines an intangible asset as identifiable if it meets either the separability criterion or
the contractual–legal criterion. If one criterion is satisfied, the identifiable intangible asset of the
acquiree can be recognised if its fair value is capable of reliable measurement (IAS 38, para. 35).
The question mentions three items:

1. brands
2. competitive position
3. market strength.
‘Competitive position’ and ‘market strength’ are typical of items not recognised as identifiable
assets in the statement of financial position. Such items do not satisfy the identifiability criteria
in IAS 38, as they cannot be separated from the entity and sold, rented, transferred, licensed
or exchanged (the separability criterion), nor do they arise from contractual or legal rights
(the contractual–legal criterion). Even though an acquirer would be willing to pay for such items,
they would be regarded as unidentifiable assets and, hence, form part of goodwill.
Many entities separately recognise their brand names as intangible assets. The illustrative
examples in IFRS 3 (Part B of the Red Book) include ‘Examples of items acquired in a business
combination that meet the definition of an intangible asset’. IFRS 3, paras IE19−21 deal with
trademarks, trade names and other intangibles that are often synonymous with brand names.
As trademarks are usually registered, IFRS 3 regards this as satisfying the contractual−legal
criterion of IAS 38—that is, future benefits can be derived from legal rights. A trademark is also
likely to satisfy the separability criterion because it can be sold. Finally, where a brand name is
regarded as an identifiable intangible asset because it satisfies the criteria of IAS 38, it can be
recognised and its fair value can be reliably measured (IAS 38, para. 35).
In conclusion, even though there are three items mentioned by the managing director, only the
brand name could possibly be regarded as an identifiable asset. The other two items would be
regarded as components of goodwill.
Question 5.4
No, some identifiable assets and liabilities may not have been recognised in the acquiree’s
statement of financial position prior to acquisition. As noted in IFRS 3, para. 13, the acquirer
may obtain control over identifiable assets and liabilities that were not previously included
in the statement of financial position of the acquiree (e.g. identifiable intangible assets
generated internally, like brand names and trademarks; or contingent assets and liabilities).
This may be because the items did not satisfy the applicable recognition criteria prior
to acquisition.
Question 5.5
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Examples of unidentifiable assets that may form part of goodwill include market penetration,
good industrial relations, strategic location, superior management, good credit rating, excellent
training programs, specialised skills and community standing. Each of these would provide future
economic benefits to the entity, but would not be recognised because it would not be possible
to reliably measure their fair value. Also, they may not satisfy the identifiability criteria in IAS 38,
as they normally cannot be separated from the entity and sold, rented, transferred, licensed
or exchanged (the separability criterion), nor do they arise from contractual or legal rights
(the contractual–legal criterion).

Question 5.6
(a) No, the costs associated with running an acquisitions department would not be included in
the cost of a business combination. General administrative costs associated with maintaining
an acquisitions department for a particular business combination are not considered part
of the cost of the business combination and should be expensed as incurred. They may be
acquisition-related costs, but the general principle is that those costs are expensed in the
periods in which they are incurred (IFRS 3, para. 53).
(b) (i) The consideration transferred should be determined as at the acquisition date, the date
when the risks and rights to future benefits associated with the investment pass to Investor.
This is not 1 April 20X5, which is the date when the agreement was signed, but 30 June
20X5, which is when the terms of the agreement were fulfilled.
The consideration transferred should be measured by reference to the fair value of what
was given up at the acquisition date (being 30 June 20X5, as discussed), not what was
received. Investor gave up 100 000 shares and their fair value at 30 June 20X5 was $5.00
per share, making the fair value of the total consideration transferred equal to $500 000.
Consulting fees cannot be included as part of the consideration transferred, as

acquisition-related costs are expensed in the periods in which the costs are incurred
(IFRS 3, para. 53).
(ii) The pro forma journal entries prepared by Investor to account for the acquisition of the
investment and the payment of acquisition-related costs are as follows:
Dr Cr
$000 $000
Investment in Investee 500
Issued capital 500
Issue of shares to acquire the investment
Consulting fees (expense) 10

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Bank 10
Acquisition costs recognised in P&L

Question 5.7
The fair value of the identifiable net assets in B is calculated as:
Fair value of total identifiable assets recorded by B $10 000 000

Add: Fair value of identifiable assets not previously recorded by B $1 000 000
Less: Fair value of total identifiable liabilities recorded in B ($5 000 000 )
Less: Fair value of contingent liability not previously recorded in B ($1 000 000 )
Fair value of total identifiable net assets of B $5 000 000
Therefore, the goodwill on acquisition is:

Fair value of consideration transferred by acquirer $8 000 000
Less: Fair value of identifiable net assets in B ($5 000 000 )
Goodwill $3 000 000
The journal entry posted by A in its own records to recognise the acquisition of all the assets
and liabilities of B is as follows:
Dr Cr
$ $
Account receivable 400 000
Inventory 600 000
Plant and equipment 2 000 000
Land and buildings 7 000 000
Trademark 1 000 000
Goodwill 3 000 000
Account payable 500 000
Bank loan 4 500 000
Provision for damages 1 000 000
Bank 8 000 000
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Question 5.8
In Example 5.6, the acquirer acquired all the assets and liabilities of a business that it now fully
owns. This acquisition is a direct acquisition and, as such the assets are transferred to the acquirer’s
accounts, which recognise them as assets of the entity, together with the previous assets it owned
prior to the acquisition. Liabilities are only directly transferred into the acquirer’s records.
On the other hand, in Example 5.7, the acquirer acquired only the shares issued by the
business that it now fully owns, but the acquiree retains legal ownership of its assets and a
legal responsibility to settle its liabilities. As such, the treatment of this acquisition recognises
that the acquirer purchases just one single asset that it needs to recognise in its own accounts.
Shareholders in the acquirer will not be able to easily identify by looking at the financial
statements of the acquirer what assets and liabilities were acquired unless they are provided
with a detailed description of the business combination.
To make it easier to understand the financial impact and the risks and opportunities facing
the acquirer as a result of this business combination via purchase of shares, IFRS 10 requires the
acquirer in these instances to prepare consolidated financial statements that will include the assets
and liabilities of all the entities within the group.
Question 5.9
The pro forma journal entry at acquisition date to reflect the acquisition of Small’s assets and
liabilities by Large is as follows:
Dr Cr
$000 $000
Inventory 200
Land and buildings 700
Goodwill 60
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Bank overdraft 30
Trade payables and loans 400
Bank† 400
Issued capital‡ 225

†
Payment of consideration in cash.
‡
Issue of shares as part of the consideration transferred.
Notes
1. The identifiable assets and liabilities acquired by Large are recorded at their fair values
at acquisition date in accordance with IFRS 3, para. 18. The amounts recorded for these
assets and liabilities in Small are not relevant to this type of business combination,
which is structured as a direct acquisition.
2. There is no deferred tax asset or deferred tax liability recognised by Large as the assets
and liabilities acquired are of such a type that their amounts recorded by Large also
establish their tax base.
3. The difference between the fair value of the consideration transferred (made out of cash
and shares) and the fair value of the identifiable assets and liabilities acquired is equal
to the goodwill, which is recognised as an asset in accordance with IFRS 3, para. 32.

Question 5.10
The pro forma journal entry at acquisition date to reflect the acquisition of Low’s assets and
liabilities by High is as follows:
Dr Cr
$000 $000
Accounts receivable 200
Inventory 850
Plant and equipment 2 600
Goodwill 350
Trade payables 100
Loans 890
Contingent liability 300
Bank† 2 800

†
Payment of consideration in cash.
Notes
1. The identifiable assets and liabilities acquired by High are recorded at their fair values
at acquisition date in accordance with IFRS 3, para. 18. This includes the contingent
liability because it is a present obligation and its fair value can be reliably measured at
acquisition date.
2. The recognition of the contingent liability has given rise to a deferred tax asset.
3. The difference between the fair value of consideration transferred and the fair value of
the identifiable assets and liabilities acquired is equal to the goodwill, which is recognised
as an asset in accordance with IFRS 3, para. 32.
Question 5.11
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(a) The degree of equity ownership is not the overriding consideration in determining the
existence of control, but the existence of voting rights attached to the shares that constitute
the equity ownership would be a factor (remember that not all classes of shares have
voting rights attached). Whether Y is a subsidiary of X will depend on whether X controls Y
(IFRS 10, para. 5). X will only have control over Y if all of the following criteria are satisfied:
–– X has power over Y through having existing rights to direct Y’s relevant activities.
–– X is exposed, or has rights, to variable returns from its involvement with Y.
–– X has the ability to use its power over Y to affect the amount of its returns
–– (IFRS 10, paras 6 and 7).
Determination of whether X has control will rely on judgments being made based on the
substance of the case. Given no other relevant factors, and assuming that X has 60 per cent of
the voting rights in Y, it would be expected that X has the power to direct the relevant activities
of Y. This power would derive from an ability to use its voting power to appoint the majority
of directors of X who direct the relevant activities of the company, including the operating
(e.g. selling goods or services, buying assets) and financing activities (e.g. obtaining funding)
of the company (IFRS 10, paras B11, B35).
X would also be exposed to, or have a right to, variable returns based on the performance
of Y. As a shareholder, X would expect to receive a return via dividends and changes in
the value of its investment. These returns could be positive or negative depending on Y’s
profitability. It does not matter that the other shareholders’ (who hold 40%) share in the
returns of Y (IFRS 10, paras 15 and 16). X may also be able to include a right to receive returns
from factors such as securing a supply of services, economies of scale or remuneration from
providing services (IFRS 10, para. B57).
Finally, it would be expected that X could use its power over Y to affect the returns it received
from the company. That is, X could use its power to increase the returns it received from Y
or reduce any potential losses.
(b) Even though X does not hold the majority of shares in Y, it can still have control of Y.
The critical issue is whether X has the power to direct the relevant activities of Y. IFRS 10,
para. B42 and Example 4 of Appendix B both suggest that it is likely that X would satisfy
the power criterion of control. This stems from both X’s absolute and relative voting rights
compared with other shareholders (IFRS 10, para. B42(a)). To outvote X, other shareholders
with a combined interest of a least 45 per cent of the shares need to act together. This would
involve hundreds of shareholders. As few of these shareholders attend annual meetings
and there is no agreement between shareholders to make collective decisions, this is
highly unlikely.
In addition to X having the power to direct the relevant activities of Y, the company must
also satisfy the other criteria for control (IFRS 10, paras 6 and 7). As a shareholder in Y, X is
exposed to returns from the company, which will vary depending on the performance of Y.
Finally, X can use its power to affect the returns from Y. As the dominant shareholder, X would
be able to influence the appointment of Y’s directors and hence the financial and operating
decisions of the company, which in turn will impact on X’s returns from Y.
(c) As with Part (b), the critical criterion of control in this situation is whether X has power over
Y. In accordance with IFRS 10, para. B42(a) and the discussion in IFRS 10, Example 6 of
Appendix B, X would not satisfy the power criterion of control. The central factor preventing
X from having power over Y is that the two other shareholders have combined voting rights of
56 per cent. Hence, these two shareholders can work together to prevent X from directing the
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relevant activities of Y. Therefore, in this case, X is not likely to control Y.
(d) IFRS 10, paras B36 and B37 discuss the situation in which an investor can have the majority
of voting rights but no power. One example of where this could occur is when another entity
has a contractual right to direct the relevant activities of the investee and is not an agent
of the investor. In such a situation, the investor does not have power over the investee.
Another example is where the voting rights are not substantive as the investor does not
have the practical ability to exercise their rights (IFRS 10, para. B22). This could occur where
the relevant activities of the investee are subject to direction of other parties, such as the
government, a court administrator or a liquidator.

Question 5.12
(a) The fair value of the consideration transferred is the aggregate of the fair value of share
capital issued as consideration. The fair value of the shares issued by Holding, at 30 June
20X3, was $5.00 per share. Hence, the fair value of consideration transferred is calculated as:
Fair value of shares issued (30 000 shares† @ $5.00) = $

150 000

†
Subsidiary has an issued capital of 12 000 shares. Holding offered five of its shares for every two of
Subsidiary and therefore issued 12 000 / 2 × 5 = 6000 × 5 = 30 000 shares as part of consideration.

(b) The pro forma journal entry for Holding to account for the acquisition of the Subsidiary’s
shares is as follows:
Dr Cr
$000 $000
Investment in Subsidiary 150
Issued capital 150
(Issue of shares to acquire shares in Subsidiary)
(c) The recognition of the identifiable net assets of Subsidiary at fair value as part of the business
combination leads to the recognition of a deferred tax liability. The amount of the deferred
tax liability is calculated as follows:
$000
Fair value of identifiable net assets 125
Less: Tax base of identifiable net assets acquired (95 )
Taxable temporary difference 30
Therefore, a deferred tax liability of $9000 ($30 000 × 30%) arises on acquisition.
Note: The deferred tax liability only arises in this situation due to the difference between the

fair value of the identifiable assets and their tax base.
The pro forma journal entry for the revaluation of Subsidiary’s non-current assets to fair value
in the consolidation worksheet is as follows:
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Dr Cr
$000 $000
Non-current assets 20
The consolidation journal entry for the revaluation of the identifiable current assets of
Subsidiary to fair value on consolidation is as follows:
Dr Cr
$000 $000
Current assets 10
Asset revaluation surplus 7
(d) The group has purchased goodwill as the fair value of the consideration transferred
is larger than the fair value of the identifiable net assets acquired (IFRS 3, para. 32).
As Holding acquired the entire issued capital of Subsidiary, there is no non-controlling
interest or previous equity interest.
The fair value of the identifiable net assets acquired by Holding is calculated as follows:
$000
Fair value of identifiable net assets before deferred tax liability 125
Less: Deferred tax liability arising on revaluation
of identifiable net assets to fair value (9 )
Fair value of identifiable net assets acquired 116
Therefore, the goodwill to be recognised by the group is determined as follows:
$000
Fair value of consideration transferred (refer to Part (a)) 150
Less: Fair value of identifiable net assets acquired (116 )
Goodwill 34
Question 5.13
The pre-acquisition consolidation elimination entries as at the acquisition date should:
1. revalue the plant acquired to its fair value and recognise a business combination reserve
(considered part of pre-acquisition equity of Subsidiary) for the after-tax increase in value
and a deferred tax liability for the tax effect
2. eliminate the investment account appearing in the financial statements of Parent, together
with the parent entity’s share of the pre-acquisition equity of Subsidiary that includes the
business combination reserve recognised on revaluation of plant and recognise any goodwill.
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1. Revaluation of plant
Remember that it is the group that has acquired the business (including goodwill) of the subsidiary.
Therefore, the requirements of IFRS 3 in terms of using the acquisition method for this business
combination are applicable in the consolidated financial statements. As such, as long as the plant
wasn’t revalued in the subsidiary’s accounts, it has to be recognised at fair value on consolidation,
just like all the other identifiable net assets.
At the acquisition date (1 July 20X0):

• The financial statements of Subsidiary recorded plant at cost of $100 000, less accumulated
depreciation of $40 000. See point 3 of Case study 5.1.
• Parent considered that the plant owned by Subsidiary had a fair value of $80 000. In accordance
with IFRS 3, the plant must be initially measured at $80 000 (i.e. fair value) in the consolidated
financial statements. See point 3 of Case study 5.1.
Therefore, the consolidation worksheet entry must decrease the gross carrying value of the plant
by $20 000 (i.e. from $100 000 down to $80 000) and decrease accumulated depreciation by
$40 000 (i.e. from $40 000 down to $nil). This is reflected in the consolidation worksheet entry as a
debit to accumulated depreciation of $40 000 and a credit to the gross carrying value of plant of
$20 000. After these adjustments, the plant is valued at fair value (an increase of $20 000 over the
old carrying amount in the records of Subsidiary), but the tax base is not affected and therefore a
taxable temporary difference is created, for which a deferred tax liability of $6 000 (assuming a tax
rate of 30%) needs to be recognised. Similar to the case of the revaluation of plant in individual
accounts, for the after-tax increase in value, a revaluation reserve has to be recognised. In this
module, the term used for the reserve created on the revaluation of the subsidiary’s assets and
liabilities to fair value in the consolidation worksheet entry is the ‘business combination reserve’.
This term is not specified by IFRS 3, and other names could be used.
The journal entry will be posted in the consolidation worksheet as follows:
Dr Cr
$ $
Plant 20 000
From the group’s perspective, the plant was acquired at a fair value of $80 000 and this is
reflected in this worksheet.
Note: Items of plant and equipment may be shown in a worksheet ‘net of accumulated
depreciation’ and hence the consolidation entry is a single adjustment to that line item. That is,
for this example, if there was no detail concerning accumulated depreciation, the $60 000 net of
accumulated depreciation amount for plant would be simply adjusted by a debit of $20 000 to
arrive at the $80 000 consolidated amount net of accumulated depreciation.
2. Elimination of the investment in the subsidiary and the pre-acquisition equity and
recognition of goodwill
Dr Cr
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$ $
Goodwill 36 000
This entry relates to the elimination of the pre-acquisition equity and the investment in the
subsidiary and the recognition of goodwill. Business combination reserve is considered a part
of pre-acquisition equity of the subsidiary because it reflects the after-tax profit-making potential
of the asset. In effect, these are pre-acquisition benefits of the plant.
The two preceding entries could be combined as follows:
Dr Cr
$ $
Goodwill 36 000
Plant 20 000
As a result of these entries, the consolidated financial statements would then:

(i) include the net assets of Subsidiary recorded at fair value
(ii) recognise the deferred tax liability arising from the business combination in accordance with
IAS 12 and IFRS 3
(iii) exclude the asset ‘Investment in Subsidiary’ because the group cannot have an investment
in itself
(iv) have a shareholders’ equity that includes the issued capital of the parent (the issued capital of
Subsidiary is owned by Parent, not shareholders external to the group) and retained earnings
of Parent (the retained earnings of Subsidiary are obtained prior to the formation of the
group and, therefore, do not belong to the group and have been eliminated).
Question 5.14
(a) For the year ended 30 June 20X2, Subsidiary would process the following depreciation entry:
Dr Cr
$ $
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As point 4 of Case study 5.1 indicates, the remaining useful life of the plant as of 1 July 20X0
is five years with a scrap value of $0. Given the carrying amount of the plant is $60 000 (see
point 3 of Case study 5.1), depreciation expense per annum in the financial statements of
Subsidiary is $12 000 (($60 000 – $0) / 5 years). This amount is annual depreciation expense for
each year subsequent to the acquisition date, including the year ended 30 June 20X2.
As discussed in Example 5.10, the P&L and OCI of the group should include depreciation
expense for the plant of $16 000. This is because the plant had a fair value of $80 000 at
the acquisition date, giving rise to annual depreciation expense of $16 000 (($80 000 – $0) /
5 years). A comparison of the statement of financial position of Subsidiary with what should
be reported in the statement of financial position of the group would reveal the following
information in relation to the plant:
Subsidiary Group
$ $
Plant 100 000 80 000
Less: Accumulated depreciation (64 000 )† (32 000 )‡
Carrying amount 36 000 48 000

†
Accumulated depreciation at acquisition date ($40 000) plus depreciation for the years ended 30 June 20X1
and 30 June 20X2 ($12 000 + $12 000) from the point of view of Subsidiary.

‡
Depreciation for the years ended 30 June 20X1 and 30 June 20X2 ($16 000 + $16 000) from the point of
view of the group.
Consolidation entries on 30 June 20X2
1. Revaluation of plant to fair value

Dr Cr
$ $
Plant 20 000
2. Depreciation entry and associated tax effect

Dr Cr
$ $
(opening balance—prior year adj.)
Depreciation expense (current year adj.) 4 000
Accumulated depreciation must be adjusted for two years’ depreciation adjustments

(20X1 and 20X2)—hence, the credit of $8000 (2 × $4000), where the depreciation adjustment
reflects the difference in annual depreciation expense between the group and Subsidiary
($16 000 – $12 000 = $4000). The debit to the retained earnings account of $4000 relates to
increased depreciation in the prior accounting period (i.e. 20X1). As an alternative explanation,
the $4000 debit to the opening retained earnings account could be considered from the point of
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view of the depreciation charges made in the financial statements of the group in the preceding
period. To illustrate, in the year ended 30 June 20X1, an additional $4000 of depreciation
expense was recognised in the P&L and OCI of the group, as compared to that of Parent plus
Subsidiary. These higher depreciation charges would have reduced the profits and, in turn,
the retained earnings of the group, as compared to the profits and retained earnings reported
in the financial statements of Parent plus Subsidiary. As a result, in the 20X2 financial year,
the opening retained earnings account of the group had to be reduced by $4000.
Dr Cr
$ $
The higher group depreciation expense in 20X1 reduces the group profit before tax, which requires
the 20X1 tax expense of the group to be reduced by $1200 ($4000 × 30%). This reduction in group
tax expense by $1200 is reflected in the credit entry to the opening retained earnings account,
as it relates to increased group profit after tax from a prior period. Hence, in the 20X2 financial
year, the opening retained earnings account of the group increased by $1200. The net effect of the
impact of the 20X1 depreciation adjustment net of tax was to reduce (debit) the opening retained
earnings of the group by $2800 ($4000 – $1200). The higher group depreciation expense in 20X2
also reduces the group profit before tax, requiring the 20X2 tax expense of the group to also be
reduced by $1200, which is reflected in the credit entry to income tax expense.
The deferred tax liability of the group after the entries above is $3600 ($6000 – $2400), as the
temporary difference relating to the plant at 30 June 20X2 is $12 000. That is, at 30 June 20X2,
the carrying amount of the plant for the group is $48 000 (see above), while its tax base is
$36 000. The tax base corresponds with the carrying amount of the plant to the Subsidiary
because the plant was not revalued for tax purposes and the tax and accounting depreciation
calculations are consistent.
3. Pre-acquisition elimination entry

Dr Cr
$ $
Goodwill 36 000
The preceding three entries could be combined as follows:
Dr Cr
$ $
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Goodwill 36 000
Plant 20 000
Accumulated depreciation must be adjusted for two years’ depreciation adjustments

(20X1 and 20X2)—hence, the debit of only $32 000 ($40 000 – (2 × $4000)), which reflects the
combined debit and credit entries to accumulated depreciation from consolidation entries 1
and 2. This entry to accumulated depreciation for $32 000 can also be confirmed by referring
to the statement of financial position extract, which illustrates that Subsidiary would have
recorded accumulated depreciation at 30 June 20X2 of $64 000, while the group should report
accumulated depreciation of $32 000.
The other entry to be explained is the debit to the retained earnings account of $82 800.
In effect, this comprises two entries: the elimination of the original pre-acquisition earnings
($80 000); and an entry relating to increased depreciation expense (net of tax) in the prior
accounting period ($4000 – $1200 = $2800). The latter reflects the fact that the parent entity
recognised the profit-making potential of the asset and was prepared to pay $20 000 more
than the carrying amount of plant. In effect, these are pre-acquisition benefits of the plant.
This is easier to see if one recalls that the revaluation of the plant entry (entry (1)) has resulted
in a credit to the business combination reserve. Of course, this is clearly a component of the
pre-acquisition equity acquired. As the asset is used, this pre-acquisition equity is reflected
over subsequent accounting periods via higher depreciation charges and lower group profits.
(b) Point 5 of Case study 5.1 states that the plant held by Subsidiary was sold on 1 July 20X2
to an external party. Therefore, Subsidiary would not need to record any depreciation for
the financial year ending 30 June 20X3. Instead, at 1 July 20X2, Subsidiary would process the
following entry to account for the sale of plant:
Dr Cr
$ $
Bank 40 000
Plant 100 000
Profit on sale of plant 4 000
Consolidation pre-acquisition elimination entry on 30 June 20X3

Dr Cr
$ $
Goodwill 36 000

The debit to opening retained earnings of $85 600 has two components: the elimination of
the original pre-acquisition profit of $80 000; and an entry relating to the two prior years’
depreciation adjustments net of tax (2 × $2800 = $5600). The rationale for the adjustment to
opening retained earnings for prior years depreciation adjustments was explained in Part (a).
Subsidiary has recorded a profit on the sale of the plant of $4000, being the difference
between the amount received for the plant ($40 000) and the carrying amount of the plant in
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Subsidiary’s accounts ($100 000 – $64 000 = $36 000). From the group’s point of view, however,
a loss of $8000 should be recorded for the sale of plant (sale price $40 000, less carrying
amount $48 000†).

†
Refer to the statement of financial position extract in the answer to Question 5.14, Part (a).
The debit to the Profit on sale of plant account for $12 000 in the P&L and OCI converts the
‘profit’ of $4000 (credit) recorded by Subsidiary to a ‘loss’ of $8000 (debit) for the group in
the consolidated P&L and OCI.
Again this reflects the fact that, at the acquisition date, the group treated the difference
between the book value and the fair value of the plant ($20 000) as pre-acquisition equity.
The group has already recognised $8000 of this amount in previous periods via depreciation
charges (refer to the debit to the retained earnings account—gross adjustment of $8000 less
tax effect of $2400, giving a net adjustment of $5600). The remaining $12 000 is treated as
pre-acquisition equity on the sale of the plant. Hence, the group will not recognise the $4000
profit in Subsidiary’s P&L and OCI, but an $8000 loss.
The reduction of the profit on the sale of the plant by the group by $12 000 compared
with Parent and Subsidiary requires the tax expense of the group to be reduced by $3600
($12 000 × 30%). As such, it is recorded entirely to income tax expense.
(c) Dr Cr
$ $
Goodwill 36 000
The $94 000 debit to retained earnings is made up two components: the elimination of
the original pre-acquisition earnings of $80 000; and the $14 000 reduction in retained
earnings via the depreciation and profit on sale adjustments, net of the tax effects of
previous reporting periods. That is, the 20X1 and 20X2 depreciation adjustments net
of tax (2 × ($4000 – $1200) = $5600) plus the adjustment for the sale of plant net of tax
($12 000 – $3600 = $8400).
The $14 000 also reflects the amount that was debited to the business combination reserve
at the acquisition date, as it involved pre-acquisition equity. This component of pre-
acquisition equity is now reflected in retained earnings, and its effects will be carried over
to every subsequent reporting period because retained earnings will always be $14 000
less than the sum of the retained earnings of Parent and Subsidiary.
Question 5.15
(a) Question 5.15(a) assumes that all of the inventory held by the subsidiary as at 30 June 20X3
was sold in July 20X3 for $50 000 to parties external to the group.
The following pro forma consolidation worksheet entries would be processed:

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Dr Cr
$ $
Retained earnings
(opening balance) 10 000

Retained earnings
Eliminations
adjustments
$000 $000 $000 $000 $000
Sales 50 50
Gross profit 10 20

Income tax expense (3) 3 (6)
Retained earnings 7 10 3 —
(opening balance)†
†
Refer to ‘Profit for the year’ of Parent in the Example 5.14 worksheet.
Group profit before tax for the year ended 30 June 20X3 (the prior year) was $10 000 less than
the sum of the profit before tax for individual entities in the group as the inventory transferred
intra-group on 1 June 20X3 was still on hand with the subsidiary and therefore the intra-group
profit was not yet realised from the group’s perspective. As that unrealised profit was not
eliminated from the parent’s accounts, the opening retained earnings at 1 July 20X3 of the
parent includes that profit. On consolidation, that has to be eliminated. Hence, the opening
retained earnings for the financial year ended 30 June 20X4 has to be reduced by $10 000
(a debit entry).
In the current financial year, the inventory has been sold to parties external to the group.
Hence, the profit on the sale should be recognised by the group. The sale would be included
in the total sales of the subsidiary, the reporting entity that held the inventory after the ‘internal’
sale. However, the cost of goods recorded in the financial statements of the subsidiary
would be overstated from the point of view of the group as it is based on the inventory
value recognised by the subsidiary—that was overstated from the perspective of the group
at 30 June 20X3 as it was recorded based on the price paid intra-group that included the
unrealised profit. Therefore, in the 20X4 financial year when the inventory is sold the cost
of goods sold has to be remeasured (reduced) to reflect the cost to the group. The credit
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entry to the cost of goods sold achieves this reduction. After processing this worksheet entry,
the consolidated profit before tax will be $10 000 greater than the combined profit before tax
of the parent and the subsidiary (refer to the consolidation worksheet extract to confirm this).
In essence, the profit recognised by the parent in the previous period is transferred to the
current period when it should be recognised by the group.
Thus, the profit on the sale of the inventory has been correctly included in the 20X4
financial year, the period during which it was sold to parties external to the group.
As the profit on the sale of the inventory has now been recognised by the group,
a corresponding increase in the income tax expense of the group should be recognised—
hence, the debit to the income tax expense.
In the 20X3 financial year, the income tax expense of the group was reduced by $3000
on the elimination of $10 000 profit. The effect of this reduction in income tax expense
‘flowed through’ the worksheet, resulting in an increase in the closing retained earnings of
the group compared with that of the parent entity plus subsidiary. Thus, the 20X4 opening
balance of the retained earnings of the group needs to be increased. This is achieved via
a credit entry in the worksheet.
Another way of viewing the two entries that adjust the opening balance of retained earnings
is that in the 20X3 financial year, the unrealised profit after tax of the group was $7000.
The elimination of this unrealised profit after tax has resulted in a lower closing balance
of retained earnings. Hence, to obtain the same result, the 20X4 consolidated opening
retained earnings has to be reduced by $7000 (the debit of $10 000 and the credit of $3000).
Finally, it should be noted that in the 20X3 consolidated financial statements, a deferred
tax asset of $3000 was recognised. During the 20X4 financial year, the profit on the sale of
the inventory was recognised in the consolidated financial statements. However, as the tax
relating to this profit has already been paid in 20X3 by the parent, no tax is payable on the
recognition of this profit by the group. In this instance, the 20X3 deferred tax asset has been
used by the group in the 20X4 financial year. Therefore, no accounting entries are required
to reinstate the deferred tax asset account.
(b) Question 5.15(b) assumes that half of the inventory held by the subsidiary as at 30 June 20X3
was sold by 30 June 20X4 for $25 000 to parties external to the group. The consolidation
elimination entries at 30 June 20X4 would include the following:
Dr Cr
$ $
Retained earnings
Inventory 5 000

Retained earnings
Consolidation worksheet after the consolidation elimination entries
Elimination
adjustments
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$000 $000 $000 $000 $000
Sales 25 25
Gross profit 5 10

Income tax expense (1.5) 1.5 (3)
Profit for the year 3.5 7
Retained earnings 7 10 3
(opening balance)†
Inventory 20 5 15
Deferred tax asset 1.5 1.5
†
Refer to ‘Profit for the year’ of Parent in Example 5.14 worksheet.
The rationale for the debit and credit entries to the retained earnings (opening balance) is
the same as the adjustments to the retained earnings (opening balance) explained in (a).
In the financial year ended 30 June 20X4, only half of the inventory that had previously
been sold within the group was sold for $25 000 to parties external to the group. Both the
consolidated cost of goods sold and consolidated asset ‘inventory’ should be recognised
at $15 000. This amount represents half of the cost of the inventory to the group, which the
parent purchased for $30 000. Therefore, the cost of goods sold recognised by the subsidiary
of $20 000 overstates the cost of goods sold of the group by $5000 (half of the $10 000).
The remaining half of the inventory on hand is still reflected in the inventory of the subsidiary
as $20 000, but its value is also overstated from the group’s perspective. Both the cost of
goods sold and the inventory remaining need to be re-measured (reduced) to reflect only
the effect of the external transactions of the group.
As the group has recognised half ($5000) of the intra-group profit previously eliminated
(refer to the consolidation worksheet extract to confirm this), the income tax expense of the
group has to be increased by $1500 (debit tax expense—30% of $5000). However, given that
the tax on the full intra-group profit was already paid, this tax expense recognised for the
group now essentially means that the group has used half ($1500) of the deferred tax asset
recognised in the 20X3 financial year. Hence, the consolidated statement of financial position
should only include the remaining deferred tax asset of $1500 for the remaining unrealised
intra-group profit.
(c) The entries processed by the subsidiary and parent for the year ended 30 June 20X3 would be:
Subsidiary
Dr Cr
$ $
Bank 50 000
Plant 100 000
Parent
Dr Cr
$ $
Plant 50 000
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Bank 50 000


The following pro forma consolidation worksheet entries would be processed for the financial
Dr Cr
$ $
Plant 10 000

Income tax expense 600
Notes
• Debit ‘Profit on sale of plant’—$10 000
In the 20X3 financial year, the financial statements of the subsidiary would include $10 000
profit on the sale of the plant to the parent entity. From the perspective of the group,
this profit should be eliminated.
• Debit ‘Deferred tax asset’ and credit ‘Income tax expense’—$3000
If the profit on the sale is eliminated, the income tax expense recognised by the subsidiary
should also be eliminated. A deferred tax asset also needs to be recognised by the group.
In future accounting periods, the group will recognise the profit on sale of the plant but will
not pay tax because the subsidiary has paid it in 20X3. Alternatively, the consolidated tax asset
of $3000 can be explained by the fact that the tax base of the plant ($50 000) is greater than
its carrying amount to the group ($40 000) and, hence, the group has a deductible temporary
difference of $10 000 and therefore a deferred tax asset.
• Credit ‘Plant’—$10 000
The Plant account has to be reduced, as it is overstated from the group’s point of view.
It is measured in the statement of financial position of the parent entity at $50 000. However,
the cost of the plant to the group was $40 000.
• Debit ‘Accumulated depreciation’ and credit ‘Depreciation expense’—$2000
The plant is being depreciated by the parent entity based on the cost to that entity
($50 000). In preparing the consolidated financial statements, the depreciation should
be measured using the cost to the group ($40 000). Both the parent entity and the group
are depreciating the plant on a straight-line basis over the remaining useful life of the
asset (five years). To relate the depreciation to the cost to the group requires a decrease
in depreciation expense of $2000 each financial year.
Note: The group should depreciate a depreciable non-current asset using the same
depreciation method and rate applied by the member of the group using the item. That is,
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the group is using up the service potential of the depreciable item at the same rate as
the member of the group that controls it. In this case, when the plant was held by the
subsidiary prior to 1 July 20X2, the group would have used the reducing-balance method
of depreciation. However, since the plant was sold to the parent, it has been used in a
different manner such that its service potential is being used up evenly. As a result, both the
parent and the group should use the straight-line basis of depreciation. The difference in
the amount of depreciation recorded by the parent entity versus the group derives from
the different cost of the plant to each entity, not from the depreciation rate being used.
• Debit ‘Income tax expense’, credit ‘Deferred tax asset’—$600
This entry is the tax effect of the preceding entry. As the group uses the plant, the intra-group
profit is recognised via depreciation charges. Hence, the income tax expense of the group
must be increased as the deferred tax asset created in 20X3 is used. That is, the group is
including the profit, but the tax has already been paid by the subsidiary when the plant was
sold to the parent entity.
After the preceding entries, the consolidated deferred tax asset is $2400. This reflects the
fact that the tax base of the plant to the group at 30 June 20X3 is $40 000 (carrying amount
in financial statements of parent entity), which is $8000 greater than its carrying
amount of $32 000 in the consolidated financial statements, and therefore a deductible
temporary difference.
Pro forma consolidation worksheet entries for the financial year ended 30 June 20X4
Dr Cr
$ $
Plant 10 000

Notes: First entry

• Debit ‘Retained earnings’—$5600
This entry reflects the net adjustment to the retained earnings account as a result of the
eliminations at 30 June 20X3 of all the effects of the intra-group transaction from 1 July 20X2.
Note that the retained earnings account always recognises after-tax profit. The decrease in
the retained earnings of $5600 needs to be recognised because of:
$
Elimination of the after-tax profit from the intra-group transaction (7 000 )
Recognition of after-tax profit realised via depreciation 1 400
Net effect on 20X3 closing consolidated retained earnings (5 600 )
In essence, the net effect on 20X3 closing consolidated retained earnings is a decrease by
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the remaining intra-group profit still unrealised from the group’s perspective at 30 June 20X3.
As the retained earnings account closing balance needs to be reduced by $5600 in 20X3,
the opening balance for 20X4 must be similarly reduced.
• Debit ‘Deferred tax asset’—$2400
This entry is related to the adjustment to the retained earnings account above in that it
represents the tax effect of considering that some intra-group profit is still unrealised as of
30 June 20X3, meaning that there are still tax benefits to be enjoyed by the group as the
tax of the remaining unrealised profit was already paid.
• Debit ‘Accumulated depreciation’—$2000
Reinstatement of reduction in 20X3 accumulated depreciation.
• Credit ‘Plant’—$10 000
Remeasurement of plant to the cost to the group.

Notes: Second entry

• Debit ‘Accumulated depreciation’, credit ‘Depreciation expense’—$2000

Remeasurement of the depreciation expense of the plant from that recorded in the parent
entity to the basis required in the consolidated financial statements.
• Debit ‘Income tax expense’, Credit ‘Deferred tax asset’—$600

Tax effect of the preceding entry. As the group uses the plant, the profit on ‘Internal sale’
is recognised via lower depreciation charges.
Question 5.16
Account $000 $000 $000 $000 $000 $000 $000
Issued capital 300 100 70 330 30 300
600 250 710 75 635
Other net assets 440 250 690

Investment in Subsidiary 160 160 —
Goodwill 20 20
600 250 160 160 710
The increase in the consolidated net assets during the 20X3 financial year reflects the profits
recorded by Parent ($100 000) and Subsidiary ($50 000). Compared with Example 5.15, the increase
in the non-controlling interest from $60 000 to $75 000 represents the non‑controlling interest
in the profit earned by Subsidiary during 20X3 (30% of $50 000) (IFRS 10, para. B94). Moreover,
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the increase in the parent equity interest of $135 000 ($635 000 – $500 000) reflects the profit
earned by Parent, $100 000, plus its share of post‑acquisition profits of Subsidiary, $35 000
(70% of $50 000).
The items recorded in the adjustments column are the pre-acquisition elimination entries.
Recall from Example 5.15 that 70 per cent of the shares were purchased for $160 000.
Therefore, the pre-acquisition elimination entry eliminates the parent entity’s 70 per cent share
of the equity in the subsidiary at the acquisition date. At the acquisition date, the issued capital
of Subsidiary was $100 000 and retained earnings was also $100 000. Therefore, the parent
entity’s share to be eliminated is $70 000 from issued capital (70% × $100 000) and $70 000
from retained earnings (70% × $100 000), as recorded in the adjustments column. As a result
of the transaction giving rise to these pre-acquisition elimination entries, $20 000 goodwill
was recognised by the group. The pre-acquisition elimination entry is repeated each year that
the consolidation worksheet is prepared and every year it eliminates the parent’s share of the
subsidiary’s pre‑acquisition equity only. The profit earned by the subsidiary after acquisition date
is post‑acquisition and, as such, increases the consolidated equity. The parent’s share of these
profits should not be eliminated as it reflects the return earned by the group after the acquisition.

Question 5.17
Non-controlling interest—30 June 20X5:
Non-controlling interest in opening retained earnings account = $33 600 (according to non-
controlling interest in closing retained earnings calculation of previous year in Example 5.16).
During the year ended 30 June 20X5, the inventory originally sold intra-group during the year
ended 30 June 20X4 was on-sold to external parties. Hence, the group would recognise the
previously unrealised profit as part of the 20X5 consolidated profit. The non-controlling interest
will be entitled to its share of this profit after tax.
Non-controlling interest in the current profit:

= 30% of (Current after-tax profit in financial statements of Subsidiary – (+) Current period
unrealised after-tax profits (losses) made by Subsidiary + (–) Current period realised after-tax
profits (losses) of the group that were originally made by Subsidiary in a prior period)
= 30% of (Current after-tax profit in financial statements of Subsidiary + Current period realised
profit on sale of inventory – Tax effect on the current period realised profit)
= 30% of ($100 000 + $40 000 – $12 000)
= 30% of $128 000
= $38 400
Note that the profit of Subsidiary for both 20X4 and 20X5 totals $300 000 ($200 000 + $100 000).
The non-controlling interest’s share of this amount is $90 000 (30% of $300 000). The non-controlling
interest in the consolidated profit for 20X4 and 20X5 is also $90 000. This consists of the $51 600
from Example 5.16 and the $38 400 calculated in this question. However, it must be stressed that
while the non-controlling interest has received over the two years its share of the profits recorded
by Subsidiary, it has only received it when the profit was included in the consolidated P&L and OCI.
In general, if the non-controlling interest is calculated over a number of periods during

which intra-group transactions take place followed by external transactions involving all the
assets originally transferred intra-group, the non-controlling interest in the profits over those
periods can simply be calculated as its share of Subsidiary’s profits. On the other hand, if the
non-controlling interest is calculated over a number of periods during which intra-group
transactions take place followed by external transactions involving only some of the assets
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originally transferred intra-group, the non-controlling interest in the profits over those periods
is calculated as its share of Subsidiary’s after-tax profits excluding the unrealised profits related
to the assets still on hand. If the retained earnings account is capturing those unrealised profits
over a number of periods, this discussion is relevant to the calculation of the non-controlling
interest in the retained earnings.
In this question, the non-controlling interest in closing retained earnings account will be
calculated as follows:
= 30% of (Closing retained earnings account of Subsidiary – Unrealised after-tax profits
of Subsidiary)
= 30% of Closing retained earnings account of Subsidiary†
= 30% of $190 000
= $57 000

†
The previously unrealised profit has now been realised by the group and there are no unrealised
profits to carry forward.
An alternative way of reconciling the non-controlling interest in the closing retained earnings
is by using the individual items making up the balance:
= Non-controlling interest in opening retained earnings + Non-controlling interest in profit –
Non-controlling interest in dividends
= $33 600 + $38 400 – $15 000 (30% of $50 000)
= $57 000
Note that it is important to understand the principles involved in measuring the non-controlling
interest and not just learn a formula. The principles have to be applied to different circumstances.
Question 5.18
(a) Completion of the consolidation worksheet
Sales 400 150 8(3a) 542
Less: Cost of goods sold (210) (70) 2(2a) (274)
4(3a)
Less: Expenses (88) (30) 2(7a) 4(4) (116)
102 50 152
Dividend income 14 — 14(8) —

Other income 4 — 4(4) —

Less: Income tax expense (36) (15) 0.6(2b) 0.6(7b) (49.8)
1.2(3b)
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Profit for the year 84 35 102.2 9.24 92.96
Retained earnings 1 July 20X1 270 68 4(2a) 1.2(2b) 303 21.24 281.76
354 103 35(1) 4(6a) 405.2 30.48 374.72
1.2(6b)
Less:
Interim dividend (10) (10) 7(8) (13) (3) (10)
Final dividend (20) (10) 7(8) (23) (3) (20)
Transfer to general reserve (20) (10) 7(1) (23) (3) (20)

Retained earnings 30 June 20X2 304 73 346.2 21.48 324.72
Issued capital 400 100 70(1) 430 30 400

General reserve 20 10 7(1) 23 3 20
Total equity 724 183 799.2 54.48 744.72
Liabilities
Trade payables 25 15 1(5) 39
Final dividend payable 20 10 7(9) 23
Other 79 52 131
Deferred tax liability 0.6(7b) 1.2(6b) 0.6
Total equity and liabilities 848 260 992.8

Current assets
Dividend receivable 7 7(9)
Trade receivables 40 18 1(5) 57
Inventory 65 22 2(2a) 81
4(3a)
Other 171 60 231
Non-current assets
Plant (net) 230 90 4(6a) 2(7a) 322
Other 215 70 285
Investment in Subsidiary 120 120(1)
Goodwill 15 (1)
15
Deferred tax asset 0.6(2b)
1.2(3b) 1.8
Total assets 848 260 175.2 175.2 992.8
Entries:
1. Pre-acquisition elimination entries
The pre-acquisition elimination entries will be:

Dr Cr
$ $
Goodwill 15 000
This first entry is the same as the pre-acquisition elimination entry recorded in 20X1 (see pre-
acquisition elimination entry (1) in Example 5.17).
MODULE 5
The next entry is explained as follows. The directors of Subsidiary transferred $10 000 from
pre acquisition retained earnings to a general reserve. As the transfer took place during 20X2,
the effect to the retained earnings is recognised as a movement during the year and does not
affect the opening balance. The journal entry posted by Subsidiary to recognise this transfer
would be:
Dr Cr
$ $
Retained earnings—transfer to general reserve 10 000

Considering that this transfer is from pre-acquisition equity, it will impact on the pre-acquisition
elimination entries prepared on consolidation at 30 June 20X2 as some of the pre-acquisition
equity that needs to be eliminated is now recognised as general reserve and a movement in
retained earnings. Thus, an additional entry is required to ensure that Parent’s share of the
entire pre-acquisition equity of Subsidiary is eliminated. In essence, the following entry simply
reverses the entry processed in the accounting records of Subsidiary, but only for Parent’s share.
Dr Cr
$ $
Retained earnings—transfer to general reserve 7 000
2a. Inventory sold in previous year from Parent to Subsidiary

Half of the inventory remained on hand as at 30 June 20X2.
Dr Cr
$ $
Inventory 2 000

In the previous financial year, the profit made by Parent from the sale of inventory to
Subsidiary was regarded as unrealised from the group’s point of view and it was eliminated
(see consolidation elimination entry (2a) from Example 5.17). The consolidation process
in 20X2, however, starts by adding together the amounts recognised in the individual
statements of Parent and Subsidiary, which are not affected by the previous consolidation
adjustments. Hence, the elimination needs to be repeated, but this time to the opening
retained earnings balance for the 20X2 financial year to reduce it by the unrealised profit of
the previous year (20X1).
Recall that Parent sold the inventory to Subsidiary in 20X1 for $9000. This amount ($9000)
will become the cost of goods sold for Subsidiary when all of this inventory is sold to
external parties. At 30 June 20X2, half has been sold, meaning cost of goods sold is $4500.
From the group’s perspective, when Subsidiary sold half of the inventory in 20X2, the cost
of goods sold (i.e. $4500 = half of $9000) included in the financial statements of that entity
would be overstated by $2000. That is, the group should record cost of goods sold upon
selling half of the inventory to external parties at $2500 (not $4500), which is half of the
original cost to the group of $5000. Also, the remaining inventory on hand at 30 June 20X2 is
overstated by $2000 (recorded as $4500 by Subsidiary when the cost to the group was $2500).
The credit entries correct both the cost of goods sold and the inventory to the cost to the
group. The credit to cost of goods sold results in an increase in the group’s profit for 20X2:
MODULE 5
in essence, the group recognises $2000 of unrealised intra-group profit from 20X1 that is now
realised due to the sale to external parties.
2b. Tax effect of preceding entry

Dr Cr
$ $

The group’s $2000 of realised profit in 20X2 requires the related income tax expense to be
recognised. In addition, $2000 of profit is still unrealised given half of the inventory is still on
hand. As such, the group still has a deferred tax asset of $600 remaining. That is, in the future,
the group will recognise the profit when the inventory is sold to parties external to the group,
but the tax has already been paid by Parent in 20X1. An alternative explanation as to why
there is a deferred tax asset of $600 relates to the fact that while the inventory is recognised
by the group at $2500, it has a tax base of $4500 (the amount recorded in Subsidiary), and this
gives rise to a deductible temporary difference of $2000, which in turn generates the deferred
tax asset.

In 20X1, the income tax expense of the group was reduced by $1200 as a result of the
elimination of unrealised profit (see consolidation elimination entry (2b) from Example 5.17).
This further resulted in an increase in the closing retained earnings of the group as compared
to Parent plus Subsidiary. The credit entry in item 2b reflects the fact that the opening retained
earnings of the group in the 20X2 financial year must be increased by the same amount.
3a. Sale of inventory from Subsidiary to Parent

Subsidiary processed the following entry for the intra-group sale of the inventory:
Dr Cr
$ $
Bank 8 000
Sales 8 000
Inventory 4 000
Parent processed the following entry for the intra-group purchase of the inventory:
Dr Cr
$ $
Inventory 8 000
Bank 8 000

From the group’s perspective, the intra-group sales revenue and cost of goods sold must
be eliminated (which will result in the elimination of the intra-group profit on the sale)
and the inventory must be remeasured to the cost to the group. Therefore, the following
consolidation elimination entry (3a) is processed:
Dr Cr
$ $
Sales 8 000
Inventory 4 000
To explain each line of this entry, the debit to Sales eliminates the credit to Sales recorded
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by Subsidiary upon the sale of inventory to Parent. Similarly, the credit to Cost of goods sold
eliminates the debit to Cost of goods sold previously recorded by Subsidiary at the time of
sale. The credit to Inventory of $4000 offsets the ‘net’ debit to Inventory recorded by both
Parent and Subsidiary at the time of sale (i.e. $8000 debit recorded by Parent minus $4000
credit recorded by Subsidiary equals $4000 ‘net’ debit). No entry is required for Bank as
the debit recorded by Subsidiary at the time of sale has already been offset by the credit
recorded by Parent.
3b. Tax effect of entry (3a)

The consolidation elimination entry for inventory requires the following tax effect entry (3b):
Dr Cr
$ $
As the group has eliminated $4000 of unrealised profit (i.e. Sales of $8000 minus Cost of
goods sold of $4000, as recorded by Subsidiary), the income tax expense of the group must
be reduced by $1200 (30% of $4000). In addition, the group must recognise a deferred tax
asset of $1200. That is, while the carrying amount of the inventory for the group is $4000,
it has a tax base of $8000 (based on the amount recognised by the holder of those assets
intra-group) and this gives rise to a deductible temporary difference of $4000.
4. and 5. Elimination of intra-group provision of services and intra-group debt resulting

from the provision of services
Parent processed the following entry for the services rendered:
Dr Cr
$ $
Bank 3 000
Other income 4 000
Subsidiary processed the following entry for the services received:
Dr Cr
$ $
Expenses 4 000
Bank 3 000

From the group’s perspective, these entries relate to parties within the group and should
be eliminated. Therefore, the following consolidation elimination entries (4 and 5)
must be processed:
Consolidation elimination entry 4

Dr Cr
$ $
Other income 4 000
MODULE 5
Expenses 4 000
Consolidation elimination entry 5

Dr Cr
$ $

There won’t be any consolidation tax effect elimination entry as there is no net impact on
the profit recognised by the group. This is because the amount of Other income eliminated
equals the amount of Expenses eliminated, meaning that the effect of these elimination
entries on consolidated profit is nil. No entry is required for Bank as the debit recorded by
Parent is already offset by the credit recorded by Subsidiary.

6a. 20X2 adjustment for inter-company loss on sale of plant eliminated at 30 June 20X1
Recall that Subsidiary sold plant to Parent in the previous financial year (20X1) at a loss of
$4000. In 20X1, the loss made by Subsidiary was regarded as unrealised from the group’s point
of view and it was eliminated (see consolidation elimination entry (5a) from Example 5.17).
The consolidation process in 20X2, however, starts by adding together the amounts recognised
in the individual statements of Parent and Subsidiary, which are not affected by the previous
consolidation adjustments. Hence, the elimination needs to be repeated, but this time to the
opening retained earnings balance for the 20X2 financial year to increase it by the unrealised
loss of the previous year (20X1). Therefore, the following consolidation elimination entry (6a)
must be processed:
Dr Cr
$ $
Plant 4 000

During the 20X1 financial year, the elimination of the loss on the sale of the plant resulted
in an increase in the income tax expense of the group (see consolidation elimination entry
(5b) from Example 5.17) and, consequently, a decrease in consolidated profit. The decrease
in the 20X1 consolidated profit (due to the increase in income tax expense) had the effect of
decreasing the consolidated closing retained earnings at 30 June 20X1. As the elimination
needs to be repeated, consolidated retained earnings is to be decreased (debited), but this
time to the 20X2 consolidated opening retained earnings account. Therefore, the following
consolidation elimination entry (6b) must be processed:
Dr Cr
$ $
7a. Correction of group depreciation relating to plant sold on 30 June 20X1

Recall that the carrying amount of the plant in Subsidiary’s financial statements in 20X1 is
$20 000, which is the amount reported in the consolidated financial statements. The group
must, therefore, depreciate the plant at $9000 per year (($20 000 – $2000) / 2 years). Parent,
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however, depreciates the plant based on the carrying amount of $16 000, resulting in
depreciation expense of $7000 recorded by Parent (($16 000 – $2000) / 2 years). Therefore,
the following consolidation elimination entry (7a) must be processed in 20X2 to reflect the
difference in annual depreciation recorded by Parent ($7000) and that which should be
recorded by the group ($9000):
Dr Cr
$ $

In the previous consolidation elimination entry, an increase in the depreciation expense was
recognised that decreases the group’s profit. In turn, this will result in a reduction in (credit to)
the income tax expense of the group that should be recognised on consolidation. However,
Parent pays additional tax (as it has more profit due to lower depreciation charges than the
group) and, hence, a part of the deferred tax liability recognised in consolidation elimination
entry (6b) needs to be reversed. The 30 June 20X2 consolidated deferred tax liability should
only be $600 to reflect the fact that the carrying amount of the plant to the group is $11 000
($20 000 – $9000), while its tax base, recognised based on the amount recorded by the holder
of the asset, is $9000 ($16 000 – $7000). The difference between the carrying amount and
tax base gives rise to a taxable temporary difference of $2000 and deferred tax liability of
$600 ($2000 × 30%). At the time of consolidation elimination entry 6b, deferred tax liability is
$1200. As the consolidated deferred tax liability should be $600 (and not $1200), deferred tax
liability is to be reduced (debited). Therefore, the following consolidation elimination entry
(7b) must be processed:
Dr Cr
$ $
8. and 9. Elimination of intra-group dividends

Note that the parent is entitled to 70 per cent of the interim (70% of $10 000) and final
(70% of $10 000) dividends (total = $14 000), while the remainder of the dividends is
paid to the non-controlling interest (a party external to the group). Therefore, the intra-
group dividends amount to only 70 per cent of all dividends and the effects of those
intra-group dividends will have to be eliminated on consolidation. That includes:
–– for interim dividends: 70 per cent of the interim dividend recognised by Subsidiary
and the related dividend income recognised by Parent
–– for final dividends: 70 per cent of both the declared dividend and dividend payable
recognised by Subsidiary and both the related dividend income and dividend
receivable recognised by Parent.
Therefore, the following consolidation elimination entries (8) and (9) must be processed:
MODULE 5
Dr Cr
$ $
Dividend income 14 000 †
Interim dividend (retained earnings) 7 000

†
$7000 dividend income recognised by Parent in relation to interim dividend plus $7000 dividend
income recognised by Parent on the final dividend declared.
(b) Calculation of non-controlling interest

Note: The non-controlling interest is entitled to its share of Subsidiary’s equity, as reflected
from the group’s perspective. That means that unrealised profits from intra-group transactions
that originate from Subsidiary will need to be eliminated from Subsidiary’s equity before non-
controlling interest is allocated a part of it. The intra-group sales from Parent to Subsidiary are
not relevant to non-controlling interest calculations, as it is Parent that profits from these sales.
–– Non-controlling interest in opening consolidated retained earnings:

= 30% of (Opening retained earnings balance in financial statements of Subsidiary – (+)
Unrealised after-tax profits (losses) made by Subsidiary in the previous period(s))
= 30% of (Opening retained earnings balance in financial statements of Subsidiary +
Unrealised after-tax loss on plant made by Subsidiary in the previous period)
= 30% of ($68 000 + ($4000 – $1200))
= 30% of ($68 000 + $2800)
= 30% of $70 800
= $21 240

This calculation is the same as the second approach used to calculate the non-controlling
interest in Subsidiary’s 20X1 closing retained earnings (see Example 5.17). Refer to the
relevant calculation presented under the heading ‘Calculations of non-controlling interest’
in the comprehensive example (Example 5.17).
–– N
on-controlling interest in Subsidiary’s profit after tax (adjusted for profit or loss on intra-
group transactions):
= 30% of (Profit in financial statements of Subsidiary – (+) Unrealised after-tax profits
(losses) made by the Subsidiary + (–) Realised after-tax profits (losses) of the group
that were originally made by the Subsidiary)
= 30% of (Profit in financial statements of Subsidiary – Unrealised after-tax profit on sale
of inventory– Realised after-tax loss on plant (via depreciation))
= 30% of ($35 000 – ($4000 – $1200) – ($2000 – $600)
= 30% of ($35 000 – $2800 – $1400)
= 30% of $30 800
= $9240
To determine the non-controlling interest in the 20X2 consolidated profit, there are two
adjustments for unrealised profits or losses resulting from the sale of assets from Subsidiary
to Parent.
irst, during 20X2 Subsidiary sold inventory to Parent for $8000. This inventory had an
F
original cost of $4000, giving rise to an intra-group profit of $4000, which is unrealised from
the group’s perspective as all of the inventory is still on hand at year-end. This unrealised
MODULE 5
profit was eliminated in consolidation elimination entry (3a), with the tax effect of this
elimination being recognised in consolidation elimination entry (3b). The profit on inventory
($4000) and associated tax effect ($1200) give rise to an unrealised profit after tax of $2800
($4000 – $1200). As this has been included in the profit after tax in the financial statements
of Subsidiary, the non-controlling interest in the consolidated profit of the group needs to
be calculated after excluding this item from Subsidiary’s profit.

econd, another adjustment to the non-controlling interest calculation stems from the
S
20X1 unrealised loss on the sale of plant from Subsidiary to Parent. During 20X2, part of
this loss was realised by the group through the plant being used and producing goods or
services for sale to parties external to the group. Therefore, the group recognised $2000
of the loss (via depreciation) and an associated tax effect of $600. However, the 20X2 profit
after-tax of Subsidiary ($35 000) does not include the loss recognised by the group. Hence,
the non‑controlling interest in the consolidated profit of the group needs to consider
Subsidiary’s profit adjusted for this loss (and the related tax effect).
–– N
on-controlling interest in Subsidiary’s closing retained earnings.
This figure can be calculated in two ways.
(i) Using the calculations of the individual items making up the closing balance of the
retained earnings account:
= Non-controlling interest in Subsidiary’s opening retained earnings (as calculated
above) + Non-controlling interest in Subsidiary’s profit after tax adjusted for profit
or loss intra-group transactions (as calculated above) – Non-controlling interest
in Subsidiary’s dividends – Non-controlling interest in transfer by Subsidiary of
retained earnings to general reserve
= $21 240 + $9240 – (30% of $20 000) – (30% of $10 000)
= $21 240 + $9240 – $6000 – $3000
= $21 480
(ii) Using the closing balance of retained earnings of the Subsidiary – (+) Any after-tax
unrealised profits (losses) made by the Subsidiary:
= 30% of ($73 000 – Unrealised after-tax profit on inventory ($4000 – $1200) +
Remaining unrealised after-tax loss on sale of plant ($2000 – $600))
= 30% of $71 600
= $21 480
The closing balance of the retained earnings of Subsidiary ($73 000) includes both the
20X2 after-tax profit from the sale of inventory to Parent and the 20X1 after-tax loss from
the sale of plant to Parent. Therefore, to determine the non-controlling interest in the
closing retained earnings of the group starting with the closing balance retained earnings
of Subsidiary requires adjustments for: the unrealised inventory profit and the loss on the
plant yet to be realised by the group at the end of the 20X2 financial year. By the end
of 20X2, after one year of use, half of the unrealised loss is still to be realised through the
use of the asset. Both of these adjustments incorporate the tax effects involved.
–– Non-controlling interest in Subsidiary’s issued capital:

= 30% of $100 000
= $30 000
–– Non-controlling interest in statement of financial position:

MODULE 5
= Non-controlling interest in Subsidiary’s issued capital (as calculated above) + Non-

controlling interest in Subsidiary’s closing retained earnings (as calculated above) +
Non-controlling interest in Subsidiary’s reserves (as calculated above)
= $30 000 + $21 480 + $3000
= $54 480

Question 5.19
(a) Consolidated statement of profit or loss and other comprehensive income for the year
ended 30 June 20X2
$
Revenue 542 000
Less: Cost of goods sold (274 000 )
Gross profit 268 000
Less: Expenses (116 000 )
Profit† before tax 152 000
Less: Income tax expense (49 800 )
Other comprehensive income —
Total comprehensive income for the year 102 200

Profit attributable to:
Non-controlling interests 9 240
Owners of the parent 92 960
102 200

†
Refer to worksheet in Question 5.18.
(b) Consolidated statement of changes in equity for the year ended 30 June 20X2
Equity attributable to owners of Parent

Non-
Issued General Retained controlling Total
capital reserves earnings Total interest equity
$000 $000 $000 $000 $000 $000
Balance 30 June 20X1† 400 281.76 681.76 51.24 733
Total comprehensive
income for the year 92.96 92.96 9.24 102.2
Dividends (30) (30) (6) (36)
Transfers to general 20 (20) — — —
MODULE 5
reserve
Balance 30 June 20X2 400 20 324.72 744.72 54.48 799.2

†
Refer to worksheet in the comprehensive example (Example 5.17).
(c) Consolidated statement of financial position as at 30 June 20X2
Equity $000 $000

Equity attributable to owners of the parent
Issued capital 400.0
Reserves 20.0
Retained earnings 324.72 744.72
Non-controlling interest 54.48
Total equity
799.2
Represented by:
Assets
Current assets
Trade receivables 57.0
Inventory 81.0
Other 231.0 369.0
Non-current assets
Plant (net) 322.0
Other 285.0
Deferred tax asset 1.8
Goodwill 15.0 623.8
Total assets 992.8
Less: Liabilities
Trade payables 39.0
Final dividend payable 23.0
Other liabilities 131.0
Deferred tax liability 0.6 193.6
Total net assets

799.2
Question 5.20
Equity accounting is applied where an investor has significant influence over an investee.
Significant influence normally stems from voting power, not ownership interest, which may or
may not reflect voting power. Whether the accounting policy is valid depends on the voting
rights attached to the securities, not the wording of the accounting policy (which refers
to a ‘shareholding between 20 per cent and 50 per cent of the issued capital’). Neither the
MODULE 5
definition of ‘significant influence’ (IAS 28, para. 3) nor the discussion of significant influence
(IAS 28, paras 5–9) focuses on ownership interest.
The accounting policy focuses on the 20 per cent quantitative test. While this test leads to a
presumption of significant influence, all prevailing circumstances should be considered before
deciding an entity is an associate. Presumably, in arriving at the conclusion that a company
is an associate, the entity has considered evidence apart from voting power, such as board
representation, participation in policy-making, and interchange of managerial personnel
(IAS 28, para. 6).

Question 5.21
(a) Investor has the following ownership interest in Z (IAS 28, para. 27):
%
Direct interest held by investor/parent 5
Indirect interest
via subsidiary—X Ltd (80% of 25%) 20
25
In preparing equity-accounted information in the consolidated financial statements,

the investor (group) would use 25 per cent to calculate its share of items such as the
profit of the associate company Z. In accordance with IAS 28, para. 27, the holdings of
the investor’s other associate (Y) are ignored. However, it should be noted that where
an associate (Y) has an interest in an associate (Z), the group’s share of Y’s profit will be
based on a profit that includes a share of Z’s profit (IAS 28, para. 27). Therefore, in essence,
the group captures the indirect interest in Z through the associate Y.
(b) While voting power is important in determining whether significant influence exists
(IAS 28, paras 5–9), it is the investor’s ownership interest in the associate company that
must be determined when implementing the equity method (IAS 28, para. 27).
(c) If the percentages recognising the ownership interest are also denoting the voting power,
then Investor, directly and indirectly via a subsidiary, has enough voting power to claim that
is able to exercise significant influence over Z (i.e. the direct and indirect voting power is
larger than 20%, the cut-off considered as enough for significant influence to exist).
Question 5.22
(a) The goodwill of $10 000 (refer to Example 5.19) will not be separately disclosed, but will
MODULE 5
remain part of ‘Investment in associate’, both in the financial statements of Investor
and in any consolidated financial statements that include the investment based on the
equity method.

When applying the equity method in subsequent accounting periods, the goodwill remains
part of the investment and must not be amortised against the investor’s share of the
associate’s profits or losses (para. 32). In addition, when testing for impairment, the focus
is the entire carrying amount of the investor’s investment in the associate, not the goodwill
determined at acquisition (para. 42).
(b) The revaluation by Investee does not affect Investor’s cost of investment. In subsequent
reporting periods, Investee’s depreciation expense relating to depreciable assets will be
higher than in the absence of revaluation. This will be reflected in Investee’s P&L and OCI.
In turn, this will flow through to Investor’s ‘share of profits’ for equity accounting purposes.
Therefore, this particular revaluation of assets by Investee does not require Investor to
make any adjustments (when equity accounting).
If the associate did not revalue the assets in its own financial statements, its P&L and OCI
would include depreciation based on original carrying amount. This would necessitate an
adjustment to the investor’s share of the associate’s profits (an equity-accounting adjustment)
so that depreciation is based on the fair value of the assets as assessed by the investor at
the time of making the investment (IAS 28, para. 32). Similar consolidation adjustments were
seen when the net assets of the subsidiary were not recorded at fair value in the subsidiary’s
Question 5.23
After equity accounting for the investment, the following information would appear in the
consolidated financial statements of Investor:
Abridged consolidated statement of profit or loss and other comprehensive income

for Investor for the year ended 30 June 20X5
$000
Other income and expenses 300
Share of profit or loss of associate† 25.2
Profit before tax expense 325.2
Profit for the year 235.2
Other comprehensive income —
Total comprehensive income 235.2
†
IAS 1, para. 82(c)
Consolidated statement of financial position of Investor as at 30 June 20X5
$
MODULE 5
Retained earnings† 195 200

Liabilities 270 000
1 125 200
Investment in Investee Ltd‡ 65 200

Other assets 1 060 000
1 125 200
†
Retained earnings of Investor ($185 000) + Share of associate’s post-acquisition increase
in retained earnings ($10 200 = $25 200 – $15 000).
‡
IAS 1, para. 54(e).

Question 5.24
Abridged consolidated statement of profit or loss and other comprehensive income
(a)
for Investor for the year ended 30 June 20X5
$000
Other income and expenses 300
Share of profit or loss of associate† 23.1
Profit before tax expense 323.1
Profit for the year 233.1
Share of other comprehensive income of associates‡ 6
Total comprehensive income 239.1

†
IAS 1, para. 82(c).

‡
IAS 1, para. 82A.

Note: The total comprehensive income includes the profit for the year, which would be
included in retained earnings, and the share of other comprehensive income, which is
reflected in equity in the asset revaluation surplus.
(b) The same elimination entry is used, no matter whether the transaction is ‘upstream’
or ‘downstream’. Hence, the pro forma journal entry processed in Example 5.21 would
also be processed if the sale of inventory was from Investee to Investor.
(c) Net assets of Investee Ltd $204 000 †

†
$184 000 according to Example 5.20 + $20 000 for revaluation of land.
$
Investor Ltd’s share of carrying amount = 30% of $204 000 = 61 200
Less: Unrealised profit on inventory‡ (2 100 )
Investor Ltd’s share of net assets 59 100
Plus: Goodwill 10 000
Equity investment in Investee Ltd 69 100
MODULE 5
As outlined in Example 5.21, the unrealised profit on inventory must be eliminated on a net basis.
‡
That is, the only accounts affected are ‘Investment in Investee’ and ‘Share of profit or loss of
associates’. The elimination reflects the investor’s ownership interest (30%) in the unrealised profit
after tax of $7000 ($10 000 × (1 – .30)). Note: The elimination is not against the individual accounts
affected as would be the case with a consolidation adjustment for unrealised profits or losses.

Question 5.25
The following consolidation worksheet entries would be processed to account for Investor’s share
of profits and losses:
Dr Cr
30 June 20X7 $ $
Share of profit or loss of associate 30 000 †
Investment in associate 30 000
†
The total share of the associate’s losses is 30 per cent of $150 000 or $45 000. However, in accordance
with IAS 28, para. 39, the investment can only be written down to zero. Hence, before the investor’s
share of subsequent profits can be recognised, its share of losses not recognised ($15 000) must be
offset (IAS 28, para. 39). That is, the associate must earn a profit of $50 000 ($15 000 / 30%).
Note: In accordance with IFRS 12, para. 22(c), the notes to the financial statements of Investor
should disclose the amount of unrecognised losses, both for the period and cumulatively.
The amount of the unrecognised losses is $15 000.
Dr Cr
30 June 20X8 $ $
Investment in associate 9 000
Share of profit or loss of associate 9 000 ‡
‡
The total share of the associate’s profits is 30 per cent of $80 000 or $24 000. However, as the share
of the associate’s losses not recognised is $15 000, only $9000 of the investor’s share of profits will be
recognised during the 20X8 financial year.
After the preceding entry, the amount of the investment in the associate will be $9000.
This amount can be reconciled as follows:
$
Investment as at 1 July 20X6 30 000
Share of losses 20X7 (30% of $150 000) (45 000 )
(15 000 )
Share of profits 20X8 (30% of $80 000) 24 000
MODULE 5
Investment as at 30 June 20X8 9 000

References | 515
References
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BHP Billiton 2015, Resourcing Global Growth: Annual Report 2015, BHP Billiton, Melbourne,
accessed July 2016, http://www.bhpbilliton.com/~/media/bhp/documents/investors/annual-
reports/2015/bhpbillitonannualreport2015.pdf.
Gas Today 2014, ‘The Gippsland Basin Joint Venture: Celebrating 50 years’, Gas Today,
accessed November 2016, http://gastoday.com.au/news/the_gippsland_basin_joint_venture_
celebrating_50_years/87604.
IASB (International Accounting Standards Board) 2016, International Financial Reporting

Standards, IASB, London.
Macdonald-Smith, A. 2016, ‘BHP Billiton joins ExxonMobil in Bass Strait oil asset sale’,
Financial Review, 15 June, accessed November 2016, http://www.afr.com/business/energy/oil/
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bhp-billiton-joins-exxonmobil-in-bass-strait-oil-asset-sale-20160615-gpjpge.
Rio Tinto 2016, ‘Rio Tinto and Sinosteel extend historic Channar Mining Joint Venture’,
Media release, 15 April, accessed November 2016, http://www.riotinto.com/documents/160415_
Rio_Tinto_and_Sinosteel_extend_historic_Channar_Mining_Joint_Venture.pdf.
MODULE 5
FINANCIAL REPORTING
Module 6
FINANCIAL INSTRUMENTS
518 | FINANCIAL INSTRUMENTS
Contents
Preview 521
Introduction
Objectives
Teaching materials
Part A: What are financial instruments?

523
Introduction 523
Claims 523
Definition of a financial instrument 524
Equity instruments
Fixed-for-fixed test
Financial assets
Liability or equity? 527
Instruments that are a mix of liability and equity 528
Contracts to buy or sell non-financial items 528
Derivative financial instruments 529
Forward contracts
Futures contract
Option contract
Swap contracts
Interest rate swaps
Summary 534
Part B: Recognition and derecognition of financial assets

and financial liabilities 535
Introduction 535
Recognition of financial assets and financial liabilities 535
Derecognition of financial assets and financial liabilities 536
Derecognising financial assets
Transfers of financial assets
Derecognition of a financial liability 544
Summary 545
Part C: Classification of financial assets and financial liabilities

546
Introduction 546
Classification of financial assets 546
Business model
Contractual cash flows that are solely payments of principal and interest
on the principal amount outstanding
Option to designate a financial asset at fair value through profit or loss
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Classification of financial liabilities 550

Option to designate a financial liability at fair value through profit or loss
Embedded derivatives
Reclassification 554
Summary 555
Part D: Measurement 556

Introduction 556
Initial measurement 556
Subsequent measurement of financial assets 557
Impairment of financial assets carried at amortised cost
Subsequent measurement of financial liabilities 559
Reclassification of financial assets
Gains and losses
CONTENTS | 519
Investments in equity securities 563

Liabilities designated at fair value through profit or loss 563
Compound financial instruments 564
Summary 566
Part E: Hedge accounting 567

Introduction 567
Hedging relationships 567
Hedging instruments
Accounting for hedging relationships 570
Types of hedges
Special accounting rules 580
Accounting for the time value of options
Assessing hedge effectiveness 581
Discontinuing hedge relationships 582
Increased disclosures 582
Summary 582
Part F: Disclosure issues 583

Introduction 583
Scope and level of disclosure 583
Significance of financial instruments for financial position
and performance 584
Statement of financial position 584
Statement of profit or loss and other comprehensive income 586
Other disclosures
Nature and extent of risks arising from financial instruments
Credit risk
Liquidity risk
Market risk
Summary 595
Review 596
References 603
Optional reading
MODULE 6
MODULE 6
Study guide | 521
Module 6:
Financial instruments
Study guide
Preview
Introduction
Financial instruments are at the core of almost every business. Some businesses are only
ever concerned with simple financial instruments, such as trade payables and receivables.
Other businesses delve into extremely complex financial instruments, such as residential
mortgage backed securities, interest rate swaps, forward exchange contracts and credit default
swaps, to name a few. This complexity is reflected in the fact that there are three accounting
standards devoted to the topic.
The three standards deal with different issues in relation to financial instruments, namely:
• when financial instruments should be recognised and derecognised and how,
once recognised, they should be measured—this, together with hedge accounting,
is the focus of IFRS 9 Financial Instruments (IFRS 9)
• the appropriate presentation of the instruments, once recognised—this is the focus of
IAS 32 Financial Instruments: Presentation (IAS 32) MODULE 6
• the appropriate information to disclose for both recognised and unrecognised financial
instruments—this is covered in IFRS 7 Financial Instruments: Disclosure (IFRS 7).
It is not necessary to understand every aspect of these three standards. In practice, both preparers
and users would specialise in an area of financial instrument accounting, for example in hedging
or in determining whether an instrument should be classified as debt or equity. The key, however,
is that preparers and users understand the general principles of these standards so that everyone,
users and preparers alike, have a common frame of reference.
Financial instruments are a key component of an entity’s prospects of remaining a going concern
because they directly affect one of an entity’s most fundamental resources: cash. Some financial
instruments can have an immediate effect on cash flows while others have a delayed, or even
magnified impact. Understanding an entity’s exposure to various financial instruments is
necessary for a user to determine if that entity will remain a going concern. Furthermore,
the types of financial instruments an entity enters into provides an insight into management’s
risk appetite, which can inform further user analysis.
This module begins by defining ‘financial instruments’, and then addresses the recognition and
measurement of financial instruments. The next section discusses the rules about presentation,
and the module concludes with a brief review of disclosure requirements.
The global financial crisis (GFC) brought about significant debate on the accounting
treatment of financial instruments under the old IAS 39 Financial Instruments: Recognition
and Measurement (IAS 39). In response the IASB was asked to review the recognition and
measurement of financial instruments as a matter of urgency.
On completion of the IASB’s major financial instruments project in July 2014, the IASB issued
IFRS 9 Financial Instruments to replace IAS 39.
The standard has a mandatory effective date for annual periods beginning on or after
1 January 2018, with earlier application permitted and with the requirement for transitional
disclosures applying. For candidate study purposes, this module will be using the version of
IFRS 9 covered in the IFRS 2017 ‘Red Book’.
Objectives
After completing this module, you should be able to:
• identify a ‘financial instrument’ and explain the difference between primary and derivative
financial instruments;
• explain and apply the criteria for the recognition and derecognition of financial assets and
financial liabilities associated with financial instruments;
• explain and apply the approach to the classification, reclassification and measurement of
financial assets and financial liabilities;
• identify the requirements in IFRS 9 for the use of hedge accounting;
• explain and apply the fair value hedge and cash flow hedge methods to simple examples;
• explain how compound financial instruments are to be measured and recognised; and
• explain the key disclosures required for financial instruments under IFRS 7.
Teaching materials
• IFRS 7 Financial Instruments: Disclosure
• IFRS 9 Financial Instruments
• IAS 32 Financial Instruments: Presentation
• Below is a link to a glossary of financial instruments and the many terms used in describing
activities and types of instruments. You may also want to consult the glossary when you
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come across an unfamiliar term.

http://www.traderslog.com/category/definitions
Study guide | 523
Part A: What are financial instruments?

Introduction
Financial instruments can be simple, such as cash, or they can be much more complicated,
such as foreign currency interest rate swaps. The majority of financial instruments are created
through legal contracts that are the product of intense negotiations, for example foreign currency
interest rate swaps represent an agreement between at least a bank and a borrower, but usually
include many more parties. Cash, however, is not explicitly a contract with another party to
provide an entity with future economic benefits, yet cash is the fundamental component of all
financial instruments. The diversity of instruments that at their core merely affect the cash flows of
an entity has added significant complexity to financial markets and the accounting standards that
are meant to specify the accounting requirements for those instruments. As such, not all financial
instruments are accounted for in the same way, despite how they might appear at first glance.
Arising from this complexity is an equally complex definition of a financial instrument in IAS 32.
The definition was crafted in an attempt to capture financial instruments that might only exist in
a small number of global organisations. Nevertheless, for anyone to understand how financial
instruments are accounted for, a firm grasp of the definition of a financial instrument is required.
This part of the module primarily focuses on IAS 32, which contains all the guidance for
classifying financial instruments.
Relevant paragraphs
To assist in understanding of certain sections in this part, you may be referred to relevant
paragraphs in IFRS 9. You may wish to read these paragraphs as directed.
Claims
Before delving into the specifics of financial instruments, it is useful to understand how the financial
instruments standards attempt to address the objective of general purpose financial reporting.
Chapter 1 of the Conceptual Framework discusses economic resources and claims, and the
changes in those economic resources and claims. Understanding these elements is fundamental
to a user’s assessment of the entity’s strengths and weaknesses.
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Claims might be recognised, or unrecognised, in the financial statements of an entity.
For example, an entity can have a claim over another entity’s economic resources, and this
claim could be classified as a financial asset. On the other hand, if another entity has a claim to
an entity’s economic resources, that claim could be classified as a financial liability or as equity.
However, claims may not be symmetrical; one entity might recognise a liability for a claim another
entity has over its resources, but that other entity might not recognise an asset for that claim.
The recognition disparity arises from the way individual accounting standards implement the
objectives of the Conceptual Framework.
IAS 32 takes these objectives of financial reporting and applies them to financial instruments.
Therefore, as you are reading this module consider how each example is classified and how the
classification reflects the claims an entity has and the claims against an entity. Keep in mind that
claims against an entity could be classified as a financial liability or as an equity interest.
You may wish to refer to Chapter 1 of the Conceptual Framework for more information.
Definition of a financial instrument

A financial instrument is defined in a deceptively simple manner. According to IAS 32, a financial
instrument creates a financial asset for one entity and a financial liability (or equity instrument)
for another entity (IAS 32, para. 11). Notice how the definition specifically requires two entities.
A financial instrument cannot exist if there are no external parties to the contract. How could an
entity expect cash from itself and owe itself cash at the same time?
Three key elements can be identified from the definition of a financial instrument:
(a) financial assets
(b) financial liabilities
(c) equity instruments.
Each of these elements are covered in this part. Moreover, financial assets and financial liabilities
could be either ‘primary’ financial instruments, or ‘derivative’ financial instruments. This part
considers primary instruments before discussing derivative instruments.
Equity instruments
Definitions of both financial assets and financial liabilities reference equity instruments. IAS 32
defines an equity instrument as one that 'evidences a residual interest in the assets of an entity
after deducting all of its liabilities' (IAS 32.11). Shares traded on a securities exchange are examples
of equity instruments. However, not all equity instruments are accounted for as equity.
Fixed-for-fixed test
Both the definitions of a financial asset and a financial liability include a reference to the
fixed‑for‑fixed test. This test requires an analysis of an option to settle a financial asset, or a
financial liability, with the entity’s own equity instruments.
This part of the module does not consider derivative instruments in any great detail. How the
fixed-for-fixed test applies to derivatives is discussed later in this module.
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If the contractual features of an instrument allow a fixed dollar amount to be settled with a fixed
number of the entity’s own equity instruments, the financial instrument will pass the fixed for fixed
test. The basis for this test is to determine whether the instrument represents an equity interest;
that is, whether it represents a residual interest (claim of the holder) in the net assets of the entity.
If, on the other hand, the settlement feature allows the settlement of a fixed dollar amount with a
variable number of the entity’s own equity instruments, that financial instrument fails the fixed-for-
fixed test.
Study guide | 525
Example 6.1: S
ettling instruments with the entity’s own
equity instruments
An entity is considering two funding scenarios and how they would be reflected in their financial
statements. The two scenarios are similar but differ in terms of settlement with either:
(a) a variable number of the entity’s own shares, equal to a fixed currency amount
(b) a fixed number of the entity’s own shares, the value of which will vary depending on the share price.
In the first scenario, the entity is required to pay a variable number of its own equity instruments to
the value of a fixed dollar amount. Consider the following table, which illustrates where the entity is
obliged to pay a number of shares equal to $1000:
Share price Quantity of shares Total value ($)

Period ($) ($1000 / share price) (Price × quantity)
20X1 0.50 2 000 1 000
20X2 0.80 1 250 1 000
20X3 1.25 800 1 000
It is evident in the preceding table that the effect of the contractual terms is that the entity is only
ever exposed to a fixed economic value. In other words, when the entity is required to settle the debt
it could purchase $1000 worth of its own shares and settle its debt with those shares. In this case,
the contract allows the settlement of a fixed dollar amount with a variable number of the entity’s own
equity instruments. Therefore, the financial instrument fails the fixed-for-fixed test and the instrument
would likely be classified as a liability (Part C discusses this in more detail).
In the second scenario the entity is able to settle the debt with 1000 of its own shares:
Share price Quantity of shares Total value ($)

Period ($) (fixed at 1000) (Price × quantity)
20X1 0.50 1 000 500
20X2 0.80 1 000 800
20X3 1.25 1 000 1 250
Now the instrument is exposed to variable returns that respond to the entity’s performance. The risk
the instrument is exposed to evidences a residual interest in the net assets of the entity. In this
case, the contract allows the settlement of a fixed dollar amount with a fixed number of shares.
Consequently, the financial instrument passes the fixed-for-fixed test and would likely be classified as
an equity instrument (Part C discusses this in more detail).
This discussion has generalised some of the aspects a preparer needs to consider when analysing MODULE 6
a contract, such as whether it is a derivative or if it is a compound instrument. These topics,
including how to account for them, are covered in more detail later in this module.
Financial assets
You may wish to refer to para. 11 of IAS 32 for the exact definition of a financial asset.
A financial asset is an asset that is:

(a) cash
(b) an equity instrument of another entity
(c) contractual right, or
(d) a contract that will or may be settled in the entity’s own equity instruments.
When an entity recognises and discloses financial assets, it is representing that the asset in some
way meets one of the listed criteria. Financial assets are important indicators of potential future
performance and therefore preparers and users alike monitor them closely.
Cash and equity instruments

Cash is simple—any money an entity holds is its financial asset. Equity instruments of another
entity are also simple—any shares an entity owns in another company are also examples of
financial assets.
Contractual rights
Contractual rights can be a tricky aspect of the definition of financial assets. Contracts that
convey the right to receive cash from, or exchange financial assets and financial liabilities with
another entity under potentially favourable terms, meet the definition of a financial asset.
Some examples include:
(a) trade receivables
(b) loans receivable (i.e. for entities—such as banks—that lend money)
(c) instruments settled with government bonds.
All of these examples entitle an entity to receive cash or another financial asset. In the case
where an entity receives government bonds on settlement of the contract, those bonds
further entitle the entity to cash from the government that issued them. Therefore, the original
instrument is classified as a financial asset.
Settlement in the entity’s own equity instruments

This aspect of the definition of a financial asset can be difficult to understand because it refers
to an entity receiving its own equity instruments in settlement of a receivable. Instruments that
may be settled in this manner are relatively rare. Consider Example 6.1 (presented earlier in
this part), which illustrated how the ‘fixed-for-fixed’ test applies to a debt instrument (a much
more common scenario). If, instead the example considered a potential financial asset, a financial
instrument that fails the ‘fixed-for-fixed’ test would likely be recognised as a financial asset.
Financial liabilities
You may wish to refer to para. 11 of IAS 32 for the exact definition of a financial liability.
The definition of a financial liability is essentially the opposite of a financial asset. Therefore,
it is not surprising that a financial liability is based essentially on:
(a) contractual obligations
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(b) settlement in an entity’s own equity instruments.
Some examples of financial liabilities include:

(a) trade payables
(b) loans payable (e.g. borrowings from a bank).
Where an entity has the option to settle a liability in its own equity instruments, that option needs
to be assessed against the fixed-for-fixed test discussed earlier. If the financial instrument fails
the fixed-for-fixed test—that is, the entity is obliged to settle a fixed dollar value by delivering
a variable amount of its own equity instruments—that financial instrument meets the definition
of a financial liability.
Study guide | 527
Refer to the previous discussion about contractual rights, but read them in the context of the
counterparty to those examples. This mirroring is intentional and reflects the IASB’s general
effort to seek symmetrical accounting treatment for all entities. This means that, when one entity
recognises a financial asset, another entity will recognise a financial liability. However, as you will
soon find out, this is not always the case.
Liability or equity?
In the earlier section about claims, it was stated that a claim could be either a financial liability,
an equity, or even have elements of both. An important area of professional judgment, and even
career specialisation, is that of classifying an instrument as either a liability or as an equity interest.
This classification is particularly important because it affects the presentation of claims against an
entity. Liability presentation implies that the entity is obliged to transfer economic resources at
some time before liquidation, whereas equity presentation indicates a claim that may only be
settled at liquidation, if at all.
Some financial statement users are particularly interested in an entity’s liquidity. They are
concerned about whether the entity has enough resources to settle the claims against it if
and when they fall due. Incorrectly presenting a financial instrument—as either a liability or as
equity—can have serious consequences.
The basic principle to presenting a financial instrument as a liability or as equity is expressed

in para. 16 of IAS 32. Essentially, if a financial instrument does, or could, require the entity to
deliver cash, or another financial asset, to another entity, that instrument is a financial liability.
Additionally, the fixed-for-fixed test needs to be considered at this stage too. If a financial
instrument passes the fixed-for-fixed test (i.e. the entity is obligated to deliver a fixed number
of shares to settle a fixed dollar amount), that financial instrument will be classified as equity.
IAS 32 provides two exceptions to the fixed-for-fixed test, which mean that some instruments
that fail the test are nonetheless classified as equity. For the purposes of this subject, however,
it is not necessary to understand these exceptions but merely to know that they exist.
➤➤Question 6.1
Angel Investor Pty Ltd (the investor) enters into a contract with Easy Business Ltd (the borrower)
to provide a $100 000 loan. Because the investor expects the borrower’s business to grow
substantially, the investor requires the borrower to settle the instrument in five years with 10 000
of the borrower’s own equity instruments. Consider the following questions:
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(a) Does this instrument meet the definition of a financial instrument? Explain your answer.
(b) If the instrument is a financial instrument, how would Angel Investor Pty Limited and
Easy Business Limited classify this instrument?
Instruments that are a mix of liability and equity

Some financial instruments contain elements of both a financial liability and of an equity
instrument. An example is convertible debt, where the lender has the option to either accept
repayment of the notes at maturity or convert the notes into shares of the issuer. Such an
instrument is classified by the issuer into its separate components of liability and equity, the latter
being an option to convert to equity instruments of the issuer. The liability component represents
the possible cash settlement feature while the equity component represents the possible equity
instrument settlement feature. Measurement of these types of financial instruments is covered
later in this module.
Contracts to buy or sell non-financial items

Contracts to buy or sell non-financial items are financial instruments when they are expected to
be settled net in cash, or for another financial instrument, or by exchanging financial instruments.
However, if an entity enters into such a contract and continues to hold it for the purpose of
receipt or delivery of the non-financial items—in accordance with its expected purchase, sale or
usage requirements—it is not a financial instrument (IFRS 9, para. 2.4). This follows because the
contractual right of one party to receive a non-financial asset, and the obligation of another
party to deliver the non-financial asset, do not involve the receipt or delivery of a financial asset.
This exception is frequently referred to as the ‘own use’ exception.
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However, it should be noted that IFRS 9, para. 2.5 allows a contract to buy or sell a non-financial
item to be irrevocably designated as measured at fair value through the statement of profit or
loss (P&L), even if it qualifies for the ‘own use’ exemption. This designation is available only at
inception of the contract and only if it eliminates or significantly reduces an accounting mismatch
that would otherwise arise.
If you wish to explore this topic further you may now read paras 11 and AG3–23 of IAS 32.
Study guide | 529
Derivative financial instruments

To this point, this part has explained primary financial instruments.
On the other hand, a derivative financial instrument derives its value from some other financial
or non-financial item, or a combination of these. For example, a derivative might derive its value
from a combination of an agreed future price of gold as compared to the current price of gold.
Typically, derivatives will have a zero fair value at inception. However, over time, as market prices
move, the value of the derivative will increase or decrease. The magnitude of these movements
will depend on the extent of the leverage included in the contract.
IFRS 9 defines a derivative as having all three of the following characteristics:

(a) Its value changes in response to the change in a specified interest rate, financial instrument
price, commodity price, foreign exchange rate, index of prices or rates, credit rating or credit
index, or other variable, provided in the case of a nonfinancial variable that the variable is not
specific to a party to the contract (sometimes called the ‘underlying’).
(b) It requires no initial net investment or an initial net investment that is smaller than would be
required for other types of contracts that would be expected to have a similar response to
changes in market factors.
(c) It is settled at a future date (IFRS 9, Appendix A, B.2).
This section briefly identifies the characteristics of four common types of derivative instruments.
You are not required to have a detailed knowledge of the technical details of these financial
instruments, but rather a broad understanding of how these instruments work and the rights
and obligations associated with each. This understanding is required in order to comprehend the
accounting issues associated with such instruments.
All derivatives have, at a minimum, the following fundamental features:

• an issuer
• a holder
• an underlying item
• settlement and maturity dates.
A contract might have a single and identical settlement and maturity date, which means the
contract is settled at maturity. This is common for forward contracts where the contract establishes
rights and obligations that are performed at a specific date in the future. Other contracts might
have multiple settlement dates in addition to the final maturity date. This is common for swap
contracts that establish rights and obligations at specified time intervals during the life of
the contract. MODULE 6
Forward contracts
A forward exchange contract arises where two parties agree, at a point in time, to carry out
the terms of the contract at a specified time in the future. It is a contractual arrangement and
is commonly used in business.
Example 6.2: A simple forward contract

Shanghai Global Air Transport (SGAT) has an ongoing aviation fuel supply contract with Chinese Fuel
Services Company. The contract guarantees SGAT its fuel needs but requires payment at current
market prices. SGAT is therefore exposed to significant risk arising from changes to the fuel price.
SGAT anticipates that it will need a significant amount of fuel from August 20X1 through to December
20X1. The increased fuel required is a result of an increase in demand for parcel shipping to the
United States for its holiday season.
In January 20X1, when the jet fuel price is $50 per barrel, SGAT negotiates a forward contract with
International Shipping Hedging Company (the issuer). In the contract, SGAT (the holder) agrees to
pay the current forward price of $55 per barrel for 1000 barrels of jet fuel (the underlying item) in July
20X1 (the combined settlement and maturity date). The contract will be settled net in cash because
SGAT is not seeking physical fuel from the issuer, but rather SGAT is seeking to fix the price of its
future fuel purchase. Accordingly, the issuer agrees to deliver the market price in cash on maturity
instead of the physical item.
The value of the forward contract is derived from the expected difference between the agreed price
and the forward price on maturity. At inception of the contract, the forward price and the agreed price
are equal, therefore the contract has no value. Over time, however, the forward price will fluctuate
and give rise to a difference with the agreed price. If that difference continues to exist to maturity
(at which time the forward price will equal the spot market price of fuel), the parties to the contract
will be required to exchange cash.
The following graph illustrates the convergence of the forward price and the market price in relation
to the agreed price.
Jet fuel price USD per barrel

75
70
65
60
Price
55
50
45
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40
Jan 20X1 Feb 20X1 Mar 20X1 Apr 20X1 May 20X1 Jun 20X1 July 20X1
Time
Market price Forward price Agreed price
The graph illustrates that the market price on maturity will be higher than the agreed price.
Therefore, the issuer is required to pay SGAT the difference between the market price and the
agreed price.
Study guide | 531
While the forward contract is settled net, the contract does have two ‘legs’: a pay leg, and a receive leg.
If the contract was not settled net (which is exceedingly rare), SGAT would pay $55 per barrel for 1000
barrels to the issuer, and the issuer would pay market price (assume $60 per barrel) for 1000 barrels
to SGAT:
Forward for 1000

barrels of jet fuel
Pay agreed price Receive market price

for fuel for fuel
Visualising the contract with a pay leg and a receive leg is particularly useful for swaps, which are
discussed later.
In the illustration above, if the market price is higher than the agreed price, the entity will receive the
difference between the market price and the fixed rate, and the derivative will be an asset for SGAT.
On the other hand, if the market price is lower than the agreed price, SGAT will pay the difference
between the two prices, and the derivative will be a liability for SGAT.
Futures contract
A futures contract is a contract to buy or sell a stated quantity of a specified item, on a
specified date in the future, at a set price. The price an entity agrees to pay (or receive)
depends on the price of that contract at the time the trade is executed. The contract is with
the exchange, which acts as a clearing house. For example, in Australia the exchange is the
Australian Securities Exchange (ASX), in Japan one exchange is the Tokyo Stock Exchange (TSE)
and in Singapore it is the Singapore Exchange (SGX).
When a contract is first acquired, the exchange requires payment of a margin deposit, which is a
proportion of the total value of the contract. From this date, the contract is continually revalued to
its current market price. As a result, if the value of a contract position decreases to a deficit position,
additional cash payments to the exchange will be required.
Open positions (where a party has only purchased or sold a futures contract) in a futures market
are not generally settled by physical delivery but by the trader entering an opposite position in
the market before maturity of the contract to close out the position. This closing out of a position
avoids the need to make or take delivery of unavailable or unwanted items, although it does not
avoid the possibility of being required to absorb substantial losses in closing out a position.
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In Australia, the SPI 200 futures index is a futures contract, the value of which is based on the
overall market performance of the top 200 shares on the ASX. Entities can buy or sell these
contracts depending on how they see the market moving in the future. Some use the SPI futures
index as a signal as to the likely movements of the physical share market for the top 200 Australian
listed companies. Similar indices exist on both the TSE and SGX.
The main differences between a forward contract and a futures contract are summarised in
Table 6.1.
Table 6.1: Forward and futures contract differences
Forward contract Futures contract
1. Item traded Delivered Not normally delivered
2. Contract Non-standardised, not exchange traded Standardised, traded in an exchange

market
3. Contract Fair value determined based on forward The fair value is determined via bid/offer
revaluation rates for similar instruments for remaining quotes on the exchange. The exchange
term (IFRS 13, Level 2 inputs) revalues the contract daily to the end
of day market price; the changes are
adjusted against the cash margin deposit
required from traders at the start of
the futures contract. Any losses must
be settled daily via margin calls on
the holder.
Fair value determined based on market

value (IFRS 13, Level 1 inputs)
Option contract
An option contract is a derivative instrument that gives the holder of the contract the right but
not the obligation to buy or sell an asset from or to the issuer (commonly called the ‘writer’)
of the contract on or before a specified date. The writer of the contract is obliged to buy or
sell the asset from or to the holder once the option is exercised. The underlying asset can be
anything of value.
The contract includes the following details:

• the exercise price, which is the amount at which the asset may be bought or sold
• whether the option gives the holder the right to buy (call option) or the right to sell
(put option) the underlying asset at the exercise price
• the maturity or expiration date—an option that can be exercised at any time up to a
certain date is called an American-type option, whereas an option that can only be
exercised at a certain date is called a European-type option
• the name of the underlying asset
• the number of units of the asset that may be bought or sold with the option.
An option contract differs from forward and futures contracts in that the option holder has the
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right but not the obligation to perform under the contract. The holder of a forward or a futures
contract must either deliver according to the terms of the contract or close out the position by
taking an opposite position.
An option contract can be a specially tailored contract called ‘over-the-counter’ (OTC), or it

can be traded on an exchange. An OTC contract provides more flexibility as to the amount
and timing. While exchange-traded options are highly standardised, they provide more
liquidity, as they can be bought and sold via the exchange. The ASX trades options in the
shares of about 50 of Australia’s largest listed companies. For example, one can buy a call
option on Wesfarmers shares. This gives the holder of the option the right to buy Wesfarmers
shares at the exercise price specified in the option contract.
Study guide | 533
➤➤Question 6.2
Compare and contrast how forward contracts and option contracts protect entities from price risk.
Which type of contract might an entity prefer to use to limit price risk?
Swap contracts
A swap contract is an arrangement whereby two counterparties contractually agree to swap
or exchange one stream of cash flows for another, over a period of time. Swap contracts
are very popular for managing cash flow risk. For example, entities swap fixed interest
payment cash flows (such as payments on a fixed interest debt) for variable interest payment
cash flows (such as variable rate loans). Swaps also allow entities to access financing in
countries they otherwise would not have the ability to borrow in. This can be achieved with
cross‑currency interest rate swaps. There are two major types of swaps: interest rate swaps
and cross‑currency swaps.
Interest rate swaps

Interest rate swaps generally involve two parties swapping fixed and floating-rate interest
obligations. Under a fixed-rate loan, the interest rate is fixed for a certain period. Under a floating-
rate loan, the interest rates are reset during the loan period.
In an interest rate swap, two parties agree to swap fixed and variable rate interest payments
based on an underlying notional principal.
Example 6.3: Fixed to variable interest rate swap MODULE 6

Assume that Credit Union A has issued $1 million of loans (for three-year terms) to customers at
fixed rates, because this is what their customers wanted. However, all of Credit Union A’s deposits are
at variable rates of interest. If interest rates rise, Credit Union A will suffer losses because it will have
to pay a higher rate of interest on deposits but will only receive a fixed rate of interest from the loans.
In another state, Credit Union B has $1 million of fixed-rate deposits for three years, and all of its
loans are at variable rates of interest. If interest rates fall, Credit Union B will suffer losses because it
will have to pay its depositors a fixed rate of interest and will receive less from borrowers as it reduces
the variable rate of interest on loans. Both credit unions would be better off if they agreed to the
following swap arrangement. A pays a fixed rate of interest to B (based on $1 million) and B pays a
variable rate of interest to A (based on $1 million). The notional principal amount is never exchanged
between the counterparties. The only exchange of money is the difference in interest payments from
one party to the other.
Cross-currency swaps
Unlike interest rate swaps, a cross-currency swap involves the exchange of principal and interest
payments for a loan in one currency for principal and interest payments in another currency.
The currency principals are normally exchanged at the outset of the swap and re-exchanged at
its conclusion.
As with an interest rate swap, the reasons for cross-currency swaps can be found in the
comparative advantage of some parties to borrow funds in certain countries. For example,
assume a US company has borrowed Australian dollars (AUD) in the Eurobond market, and
agreed to pay lenders a fixed rate of 4 per cent. The US company then executes a cross-currency
swap with a US bank to:
• exchange the AUD proceeds in return for USD proceeds at inception
• pay the US bank a floating rate of interest based on USD LIBOR (London InterBank Offer
Rate) plus 1 per cent over the life of the loan
• receive from the US bank a fixed AUD interest amount of 4 per cent over the life of the loan
• on maturity pay the initial USD proceeds back to the bank in exchange for receipt of AUD
proceeds from the bank.
The cross-currency swap has been utilised by the US company to effectively convert the AUD
fixed Eurobond into a USD loan at LIBOR plus 1 per cent loan. This enables the US company to
save 0.5 per cent because a similar USD bond in the US market would incur an interest charge of
USD LIBOR plus 1.5 per cent over the same term.
You should now study Appendix A ‘Defined terms’ in IFRS 9 and consult the financial instruments
glossaries listed under ‘Teaching materials’ when you are unsure of the meaning of any term.
Summary
Part A of this module has introduced the topic of financial instruments. To master the accounting
treatment for financial instruments, it is necessary to understand the nature and characteristics
of such instruments. Part A has included the definitions of a financial instrument, financial asset,
financial liability and equity instrument from the accounting standards, and has looked at different
types of financial instruments (starting with primary instruments, through to the more complex
derivative instruments). Part A then discussed the meaning of derivative financial instruments
in more detail, as it is the derivatives that create the more complex accounting problems.
It examined the characteristics of forwards, futures, option and swap contracts as the main
types of derivative financial instruments. While it is not essential to be an expert in derivatives,
it is important to have a general understanding, and to make use of the links in the readings
section if there are terms that need more clarification.
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Part B considers the recognition, derecognition and measurement issues associated with
financial instruments, as detailed in IFRS 9.
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Part B: Recognition and

derecognition of financial assets
Introduction
Part B begins by examining whether all financial instruments should result in the recognition
of financial assets and financial liabilities. This applies the principles from IFRS 9 and looks at
the conditions under which financial assets and financial liabilities should be removed from the
Relevant paragraphs
To assist in understanding certain sections in Part B, you may be referred to relevant paragraphs
in IFRS 7, IFRS 9 or IAS 32. You may wish to read these sections as directed.
Recognition of financial assets

Paragraph 3.1.1 of IFRS 9 requires the initial recognition of a financial asset or financial liability
when an entity becomes party to the contractual provisions of the instrument. As such,
all financial instruments result in the recognition of financial assets and financial liabilities.
This may not always result in the reporting of an amount on the statement of financial position
because at inception the fair value of the financial instrument could be zero (as is the case with
many derivative instruments). Paragraph 42 of IAS 32 requires the financial asset and financial
liability to be set off under certain conditions, which most derivatives will normally satisfy.
The normal recognition criteria—as stated in the Conceptual Framework—require an asset or

a liability to be recognised when:
(a) it is probable that any future economic benefit associated with the item will flow to or from
the entity
(b) the item has a cost or value that can be measured reliably.
The Conceptual Framework recognition criteria are implemented in Chapter 3 of IFRS 9. MODULE 6
Given the complexity of financial instruments generally, the recognition and derecognition
requirements are quite lengthy.
The assumption of risks and rewards exposes an entity to the potential for gains and losses
inherent in a financial instrument. A financial instrument involves contractual arrangements that
ensure that parties who stand to gain may insist on performance from the parties who stand
to lose.
Whether the cost or other value can be reliably measured is a matter of judgment. In arm’s
length transactions, where a cash consideration is involved, the amount to be recognised can be
measured reliably. However, transactions such as the issuance of shares to acquire an investment
require reference to the fair value of the shares issued. Measurement is discussed in Part D.
Derecognition of financial assets

The recognition requirements for financial instruments are quite easy to satisfy, and therefore
relatively simple to understand. However, IFRS 9 specifies very strict requirements for the
derecognition of financial assets and financial liabilities. The strict requirements arise partly
because the IASB tries to limit the opportunity for entities to structure their contracts in such
a way that the entity could obtain financing without recognising a liability for that financing.
However, this approach causes some issues of its own. For example, an entity might transfer
practically all of the contractual cash flows of a financial asset or a financial liability, except for
some key contractual rights or obligations. Those remaining contractual rights or obligations
could very well cause the entity to continue to recognise the original financial instrument,
but also require it to recognise a new financial instrument too.
Understanding IFRS 9’s derecognition requirements is important for both preparers and
users of financial statements. If an entity fails to properly derecognise a financial instrument,
and instead is required to continue recognising the existing instrument and recognise a new
one, users need to understand how this affects the entity’s future cash flow.
Derecognising financial assets

IFRS 9 requires entities to assess whether the derecognition rules apply to a part of a financial
asset or to the entire financial asset. Paragraph 3.2.2 of IFRS 9 outlines three conditions
under which the derecognition requirements are applied only to part of a financial asset.
These conditions are straightforward and relate to situations where agreements have allowed
counterparties the rights to only a portion of the cash flows from a particular financial asset
or groups of financial assets.
Paragraph 3.2.2 of IFRS 9 essentially states that an entity will apply the derecognition criteria
to only a portion of the transferred cash flows, if the entity transfers:
(a) a specifically identified cash flow (such as the principal repayment portion of principal and
interest repayments)
(b) a pro-rata portion of all cash flows (such as 50% of all cash collected), or
(c) a pro-rata portion of specifically identified cash flows (such as 50% of the principal repayment
portion of principal and interest repayments).
If none of these conditions are met, the entity applies the derecognition criteria (discussed in
the next section) to the whole instrument.
Paragraph 3.2.3 of IFRS 9 states that a financial asset shall be removed from a statement of
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financial position when:

• the contractual rights to the cash flows from the financial asset expire (e.g. the entity collects
all amounts owing from debtors or a bank collects amounts owing from borrowers), or
• the entity transfers the financial asset in accordance with conditions specified in paras 3.2.4
and 3.2.5, and the transfer qualifies for derecognition in accordance with para. 3.2.6 of IFRS 9
(discussed in the next section).

In recent years, securitisation transactions have become popular, particularly with financial
institutions. Such transactions are not as straightforward as the traditional collections described
above (in the first bullet point). A securitisation transaction occurs where an entity issues
securities backed by the underlying cash flows associated with all or part—of one or more—
of its financial assets, such as mortgage loans or credit card receivables. These types of
transactions provide the issuer with immediate access to cash.
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Central to the issues surrounding the subprime market and the GFC is the role of financial
instruments and, in particular, derivative financial instruments. Collateralised debt obligations
(CDOs) are one example of a financial instrument now common in the world’s financial markets.
CDOs are described by the OECD (2013) as:

bonds whose income payments and principal repayments are dependent on a pool of instruments.
Typically, a CDO is backed by a diversified pool of loan and bond instruments either purchased in
the secondary market or from the balance sheet of a commercial bank.
Different CDOs are classified into different tranches, with different ratings allocated based on
underlying asset quality and the probability of repayment (e.g. AAA rated would indicate a higher
level of quality than a BB rated CDO).
Essentially, what CDOs do is convert a bank’s mortgage-backed assets into cash, so that the
bank can, in turn, lend more money. The purchaser of a CDO has a security that is backed by
the mortgages the bank has issued to its customers. If these customers default, the CDO loses
value and potentially becomes worthless. The ratings relate to the credit status of the borrower
and, as you can see, some are rated very high (AAA) while others are unrated and therefore carry
a higher risk. The higher-risk CDOs offer a higher interest rate, but this is of little value in the case
where the original mortgage borrower cannot make repayments (OECD 2013).
The question to be resolved is: ‘Does a transaction like a CDO constitute a sale of the financial
asset or is it a financing transaction which, therefore, gives rise to a liability?’ This question was
also raised at the G-20 Leaders Summit in London in April 2009.
The issue of when to derecognise a financial asset is addressed in paras 3.2.3 to 3.2.23 of
IFRS 9. This section of IFRS 9 has been amended on several occasions, reflecting the complexity
involved. These paragraphs apply to the complex transactions—for example, securitisations—
rather than the more straightforward types already mentioned.
When an entity transfers a financial asset to another entity under any arrangement (i.e. via a
securitisation or otherwise), it is either going to record a sale of the financial asset or the creation
of a collateralised borrowing, as evidenced by the two following alternative journal entries:
Sale of financial assets

Dr Cr
$ $
Cash XXXX
Financial asset XXXX
The sale may also be accompanied by a gain or loss on sale and this would be part of the
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journal entry.
Borrowing
Cash XXXX
Loan payable XXXX
Accounting for a securitisation is an extremely important issue and a whole industry has
developed around securitisations. If transactions currently treated as a sale were required to be
treated as a borrowing, part of the attraction of securitisation would be eliminated. This is not
dissimilar to the impact on leasing when the leasing standard was issued requiring the recognition
of assets and liabilities for finance leases. The reason concerns the impact on statement of
financial position ratios, such as debt to equity.
Paragraph 3.2.7 of IFRS 9 discusses exposure to variable returns as an important test in deciding
whether a sale or a loan should be recognised. For example, if A sells a financial asset to B and
agrees to purchase the same financial asset back in six months at a fixed price, A is still exposed
to the risks and rewards of the financial asset and a sale has not occurred. Conversely, if A agreed
to purchase the same financial asset in six months at the fair value at that time, B is subject to the
variability of returns from holding the financial asset and a sale should be recognised.
Example 6.4: Sale of financial assets

Consider the following two scenarios:
(a) ABC sells a financial asset to XYZ, with a carrying amount of $100 000 for $150 000.
(b) Assuming the same details outlined in (a), ABC enters an agreement with XYZ whereby ABC will
repurchase the financial asset from XYZ in six months for $175 000.
Are the two scenarios the same? Should ABC record a sale in both cases?
(a) Clearly the two cases are different. In the first case, ABC has sold the financial asset and the journal
entry to record the sale of a financial asset and a gain on sale would be:
Dr Cr
$ $
Cash 150 000
Financial asset 100 000
Gain on sale 50 000
(b) In the second case, ABC is clearly committed to repurchasing the financial asset in six months.
The sale does not qualify for derecognition because ABC is still exposed to the risks and rewards
of ownership. To record a sale and a gain, and then record the purchase of the same financial
asset at an increased value, would not be accounting for the substance of the transaction between
the two entities. The journal entry for the second case should reflect the economic substance
of the transaction. Initially, this would be to record a loan from XYZ:
Dr Cr
$ $
Cash 150 000
Loan payable 150 000
To record a loan from XYZ.
And then six months later, the journal entry should record the repayment of XYZ:

Cash 175 000
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In the second part (b) of the previous example, the sale does not qualify for derecognition
because ABC is still exposed to the risks and rewards of ownership. The repurchase agreement
affects a lender’s return. Therefore, the journal entries will reflect the economic substance of the
transactions (i.e. that it is a loan). ABC has borrowed $150 000. When an amount of $175 000
is subsequently paid, the additional $25 000 is treated as an interest expense as shown in the
second journal entry that is dated six months later.
Developing rules to provide guidance on this issue has been, and continues to be, difficult.
The G-20 Leaders Summit in London in April 2009 called on the IASB to develop a comprehensive
accounting standard on financial instruments to improve the transparency of transactions like
those associated with securitisation.
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To provide guidance on whether transfers of financial assets qualify for derecognition and
the use of sale accounting, IFRS 9 focuses on the risks and rewards of ownership. An entity
derecognises a financial asset when the cash flows from the financial asset expire or are
transferred under certain conditions that centre on whether the transferor continues to be
exposed to substantially all the risks and rewards of ownership (IFRS 9, para. 3.2.3).
The critical issue is determining when a transfer meets the requirement of transferring
substantially all the risks and rewards of ownership. In the above cases, when an entity transfers
financial assets to a third party for cash and has no continuing involvement in the financial
assets, a sale has occurred. The complication arises when the purported sale is accompanied
by certain conditions.
For example, how should an entity record the transfer of $1 million of debtors to a third party
when it guarantees to reimburse the third party for all bad debts? One alternative is to view the
two transactions as one. Therefore, the transferor is still effectively exposed to substantially all
the risks associated with the debtors, as the major risk from debtors is the risk of not collecting
the amounts owing. This is consistent with a ‘substance over form’ approach and, using this
argument, the transferor should not record a sale but should record a loan.
Alternatively, the second transaction is recorded separately as a guarantee, in the same way as
an independent party not connected with the debtors would record a guarantee. IFRS 9 argues
that where the transferor is still exposed to substantially all the risks of ownership, a sale has not
occurred. Instead, the transaction should be recorded in the books of the transferor as a loan.
Another complication can arise when the transferor is obligated to repurchase or reacquire,
or the transferee has a put option in respect of the transferred financial assets, at a price
that provides a return to the transferee similar to that which would be earned by a lender.
This suggests that a sale has not occurred.
The scenarios discussed apply the principle of an assessment about the transfer of the risks and
rewards of ownership in deciding whether the transaction should be recorded as a sale of the
financial asset. Paragraphs 3.2.4 to 3.2.6 in IFRS 9 provide guidance for the assessment relating to
the transfer of a financial asset. These paragraphs deal with situations where an entity has either:
• transferred the contractual rights to receive cash flows of the financial asset, or
• retained the contractual rights to receive the cash flows but then passed these cash flows
to another entity (a ‘pass-through’ arrangement).
A pass-through arrangement occurs where the transferor continues to receive cash flows from
a transferred financial asset but simply passes the cash flows through to another unrelated
entity. Pass-through arrangements are common where it is difficult to transfer the legal title
to a financial asset. For example, in order to transfer legal title an entity might need to notify, MODULE 6
and obtain agreement from, all counterparties to the sale. This could be onerous, in which case
the entity enters into a contract to transfer the cash flows instead. Paragraph 3.2.5 of IFRS 9
specifies the conditions for an arrangement to meet the test of a pass-through arrangement.
These conditions are that:
• the transferor has no obligation to pay any amounts to the transferee unless it collects
equivalent amounts from the financial asset
• the transferor is prohibited from selling or pledging the transferred asset
• the transferor has an obligation to pass the cash flows to the transferee without material delay.
Paragraph 3.2.6 of IFRS 9 deals with situations where an entity actually transfers a financial asset
and requires an entity to evaluate the risks and rewards of ownership of the financial asset and
requires that:
• Where substantially all risks and rewards of ownership are transferred, the financial asset is
derecognised. If the transferor retains any rights or obligations, new assets or liabilities are
recognised.
• Where an entity retains substantially all risks and rewards of ownership, the financial asset
is not derecognised.
• Where the entity neither retains nor transfers substantially all the risks and rewards of
ownership, a decision is made about the control of the financial asset. Generally, the test
for loss of control relates to the transferee’s ability to sell or pledge approximately the full
fair value of the transferred asset. Where the transferee is free to do this, the transferor has
lost control of the transferred asset; the financial asset is derecognised, and any new rights or
obligations arising from the transfer are separately recognised.
• Where the transferor retains control, the entity shall continue to recognise the financial asset
to the extent of the continuing involvement in the financial asset.
Example 6.5: Sale of financial assets at amortised cost

Company T is deemed to have sold financial assets measured at amortised cost to Company P, and the
details are as follows:
$
Financial assets carrying amounts 500 000
Cash received 600 000
Journal entry
Dr Cr
$ $
Cash 600 000
Financial assets 500 000
P&L (gain on sale) 100 000
The entry to record the sale of the securities.
Transfers that qualify for derecognition

Some transactions involving a transfer of financial assets may also result in the creation of a new
financial asset or financial liability. In such cases, paras 3.2.10 and 3.2.11 of IFRS 9 state that an
entity should recognise the new financial asset or financial liability at fair value. Any gain or loss
is determined as the difference between the proceeds and:
A the carrying amount of the financial asset sold

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plus B the fair value of any new financial liability assumed

minus C the fair value of any new financial asset acquired
plus or minus D any adjustment to fair value of the financial asset sold, previously
recognised as other comprehensive income (OCI).
As a formula, this would be shown as:
Gain (Loss) = Proceeds – (A + B – C +(–) D) if fair value increase (decrease) previously reported
as OCI
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Applying the figures from the next example (Example 6.6) to the formula results in the following
equation:
Proceeds 950 000

A 900 000, carrying amount of financial assets sold
B 20 000, the financial guarantee liability assumed
C 0, the entity does not acquire any new financial assets
D 0, the receivables were carried at cost, no adjustments were recognised in OCI
$30 000 = $950 000 – ($900 000 + $20 000)
The entry to derecognise a financial asset is to remove the carrying amount of the financial asset
and record the proceeds received or receivable. This entry may well result in a gain or loss that
is recognised in P&L.
Example 6.6: Transfer of financial asset with derecognition

Belhop Enterprises Ltd (Belhop) transfers certain receivables with a carrying amount of $900 000 (made up
of gross receivables of $950 000 and allowance for doubtful debts of $50 000) to Debt Factoring Ltd
(Debt Factoring) for $950 000. Belhop guarantees Debt Factoring for default losses for receivables up to
$20 000. Actual losses in excess of this amount will be assumed by Debt Factoring. Therefore, Belhop has
transferred the risks and rewards with the receivables (beyond $20 000) to Debt Factoring, meaning that
Belhop has lost control of the receivables and therefore a sale is recorded. Recorded journal entries
for Belhop, assuming the fair value of the guarantee is measured as $20 000, are as follows:
Dr Cr
$ $
Cash 950 000
Allowance for doubtful debts 50 000
Receivables 950 000
Guarantee liability 20 000
Gain on sale—P&L 30 000
This entry records the sale of financial assets and the recognition of a guarantee for losses on the
receivables sold.
➤➤Question 6.3
MCL Pty Ltd (MCL) is a wholesaler of chemicals and a distributor of imported soaps and perfumes.
In the three financial years to 30 June 20X6, the company reported losses totalling $6.4 million.
These losses were largely due to the adverse effects of a devaluation of the AUD and the impact
of significantly increased price competition from the other chemical wholesalers in the region.
MODULE 6
To sustain operations during this period, MCL had substantially increased its level of leverage to
a record high as at 30 June 20X6. However, continued trading difficulties throughout the 20X7
financial year necessitated a further inflow of borrowed funds to meet pressing commitments.
In May 20X7, after having increased leverage to a level equivalent to the debt-to-total-assets
covenant in the company’s debenture trust deed, it was apparent that MCL’s financial plight was
desperate. Although the January 20X7 purchases on credit had not been settled, it was evident
that no additional equity funds would be forthcoming, at least in the short term, owing to the
company’s recent results and precarious statement of financial position.
The chief executive of MCL was very anxious when approaching International Co-op Loans Centre
(‘International’), a newly established financial institution in the region. International had adopted
a high profile since launching its operations in February 20X7, and projected a ‘glossy’ image
in its marketing campaigns. After a series of meetings with International’s management in the
last week of May, an unusual arrangement was entered into by the two parties on 2 June 20X7:
• MCL sold 35 per cent ($500 000) of its trading stock to International for a $2 million immediate
cash settlement.
• MCL agreed to buy back the same stock in three months for $2.4 million.
• The trading stock sold to International was to remain in MCL’s warehouse. A monthly rental
fee of $200 was payable to MCL for the space made available for this purpose.
MCL’s statement of profit or loss and other comprehensive income (P&L and OCI) looked much
healthier for the 20X7 financial year, with a profit of $82 500 after including the $1.5 million gain
from the sale of trading stock to International.
Although MCL did not show a liability in respect to the transaction for the year ended 30 June
20X7, there was a footnote reference in the accounts to contracts entered into for the purchase
of trading stock.
How should MCL record the transaction on 2 June 20X7? Prepare the appropriate journal entry.
For the purposes of this exercise, ignore the rent received by MCL.
Dr Cr
$ $
Accounting for transfers that do not qualify for derecognition

Paragraph 3.2.15 of IFRS 9 provides guidance as to the appropriate accounting for transfers that
do not qualify for derecognition. It requires entities to account for a transferred financial asset in
its entirety as a collateralised borrowing. This means the entity should recognise a loan equal to
MODULE 6
the consideration received for the transferred financial asset that is not derecognised. In addition,
Part F will show that IFRS 7 requires certain disclosures about such transactions.
Continuing involvement in transferred assets

Paragraphs 3.2.16 to 3.2.21 of IFRS 9 deal with transfers where the transferor neither transfers
nor retains substantially all the risks and rewards of ownership of a transferred asset, and retains
control through some form of continuing involvement in the financial asset.
For example, a continuing involvement occurs in all of the following:

• The transferor transfers $5 million of debtors to another entity, but guarantees the transferee
for all losses of bad debts up to $1 million. Similar to Example 6.6, the $5 million debtors
balance is derecognised and at the same time the transferor will also recognise a financial
liability for $1 million.
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• The transferor writes a put option for the transferee for the $5 million of debtors. This option
allows the transferee (being the holder of the option), at its discretion, to require the
transferor to repurchase (or ‘put’) the debtors at any time before the option’s maturity.
In this case, none of the debtors is to be derecognised, as the transferor has a continuing
involvement with the total amount of debtors transferred. The extent of the involvement
with written put options measured at fair value is the lower of the fair value of the transferred
financial asset and the option exercise price.
Notes:
• The transferor/writer of a put option sells another party the right but not the obligation to sell an
underlying asset (in this case debtors) to the writer of the option for a specified price.
• The transferee/purchaser of a call option buys from another party the right but not the obligation to
buy an underlying commodity (in this case debtors) from the writer of the option at a specified price.
The continuing involvement may result from the contractual provisions in the initial transaction
or may arise in a separate transaction (i.e. an option). This is why none of the debtors can be
derecognised by the transferor in the second example above.
Example 6.7: Transfer of financial asset without derecognition

ABC Ltd (ABC) sells to XYZ Ltd (XYZ) shares in PQR Ltd (PQR) for $100 000. The unlisted shares have a
carrying amount of $80 000 in the books of ABC and are estimated to have a fair value of approximately
$80 000. In another transaction, ABC agrees to repurchase the shares in three months for $110 000.
The value of PQR shares has remained static for the past two years.
Analysis
ABC has a continuing involvement in the PQR shares and is required to repurchase the shares at a
price that resembles a lender’s return. Therefore, the transfer fails the derecognition rules. The entry
to record the transaction in the books of ABC is as follows:
Dr Cr
$ $
Cash 100 000
(This records a loan payable to XYZ and the asset, PQR shares, continues to be recognised
in the financial statements of ABC.)
Three months later, to record the repayment of the loan and interest to XYZ):

Cash 110 000 MODULE 6
XYZ would not recognise the PQR shares as an asset but would recognise a receivable due from ABC.
If you wish to explore this topic further you may now read paras 3.2.1–21 and B3.2.1–13 of IFRS 9.
All transfers
Paragraph 3.2.22 of IFRS 9 indicates that a transferred asset and any associated liability shall not
be offset. Paragraph 3.2.23 of IFRS 9 outlines requirements when a transferor provides collateral
to a transferee. Where the transferee can sell or repledge the collateral, the transferor shall
reclassify the asset so that a reader of its financial statements would be alerted to the status of
the collateral. Where a transferee sells the asset provided as collateral, it shall recognise a liability
measured at fair value for its obligation to return the collateral. Where a transferor defaults,
it shall derecognise the asset and the transferee shall recognise the collateral as its asset initially
measured at fair value.
It is important to note that transfers of financial assets are incredibly complex. One example is
when an entity undertakes a securitisation transaction, which is a complex borrowing arrangement.
Expert advice is usually required to accurately account for transfers of financial assets.
The examples in para. B3.2.16 provide useful guidance in the application of the derecognition
principles in IFRS 9.
Derecognition of a financial liability

The extinguishment of financial liabilities occurs when the debtor pays cash or other financial
assets to the creditor and is relieved of its obligation for the liability. Paragraph 3.3.1 of IFRS 9
states that a debt is extinguished when the obligation is discharged or cancelled, or expires.
Alternatively, the debtor is released from being the primary obligor under the liability either by
a court or by the creditor. There are also transactions involving debt defeasance where a debtor
transfers assets into a separate entity established solely to repay the creditor with the proceeds
of the transferred assets. Such transactions are generally referred to as ‘in-substance defeasance’.
Should such a transaction be accounted for as an extinguishment of the financial liabilities?
Paragraph B3.3.3 of IFRS 9 states that, unless there is a legal release of the debtor, the financial
liability has not been extinguished.
Paragraph 3.3.2 of IFRS 9 states that, where there are substantial modifications to an existing
debt instrument or where a new debt instrument with substantially different terms is issued to
replace an existing debt instrument, the old debt should be extinguished. The recording of the
extinguishment of the old debt may result in the recognition of a gain or loss in accordance with
para. 3.3.2 of IFRS 9.
Example 6.8: Modification of a financial liability

Lim Lam Ltd (Lim Lam) has experienced a delay in a construction project resulting in short-term
difficulties in meeting loan payments. This results in Lim Lam agreeing to a significant restructure
of its current loan arrangement with its bank. The current carrying amount of the loan is $500 000.
The bank agrees to extend the term of the loan from one to two years and increase the interest rate
by 10 per cent. The fair value of the loan is now $560 000.
The journal entry to record this transaction is:
Dr Cr
$ $
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Loss on loan restructure 60 000

Original loan payable 500 000
New loan payable 560 000
In accordance with IFRS 9, para. 3.3.2, there have been significant modifications to the original loan,
resulting in extinguishment of the old loan, and the new loan is recognised at fair value.
If you wish to explore this topic further you may read paras 3.3.1–4 and B3.3.1–7 of IFRS 9.
Please now attempt Question 6.4 to apply your knowledge of this topic.
Study guide | 545
➤➤Question 6.4
(a) A bank agrees to accept shares in Won Ton Ltd (Won Ton) in settlement of an outstanding
loan. The loan amount outstanding is $235 000. Two hundred thousand shares in Won Ton
are issued to the bank. The fair value of the shares in Won Ton on the date of the agreement
is $1 for each share.
What is the journal entry in the books of Won Ton to record this transaction?
Dr Cr
$ $
(b) Shin Nee Ltd (Shin Nee) establishes a trust and transfers $1 million to the trust for the
purposes of servicing a $1.3 million loan to a bank.
Show how Shin Nee should record this transaction and explain your reasoning.
Dr Cr
$ $
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Summary
Part B discussed the recognition and derecognition issues associated with financial instruments
as specified in IFRS 9. Points covered include the following:
• Financial assets and financial liabilities arising from financial instruments are recognised when
the entity becomes a party to the contract.
• Financial assets should only be derecognised when an entity loses control of the economic
benefits either through the expiry or transfer of the economic benefits.
• Financial liabilities should only be derecognised when the obligation is extinguished.
As Part B has considered the recognition and derecognition of financial instruments, Part C will
now cover the classification of financial assets and financial liabilities as outlined in IFRS 9.
Part C: Classification of financial assets

Introduction
Part C looks at the classification of financial assets and financial liabilities, which affects how
these assets and liabilities are to be measured. This part applies the principles from IFRS 9,
and concludes with the rules for reclassification of financial assets and financial liabilities.
Relevant paragraphs
To assist in understanding certain sections in this part, you may be referred to relevant paragraphs
in IFRS 9 or IAS 32. You may wish to read these paragraphs as directed.
Classification of financial assets

Paragraph 4.1.1 of IFRS 9 requires entities to classify financial assets upon initial recognition,
to be subsequently measured at either amortised cost or fair value on the basis of both:
• the entity’s business model for managing the financial assets
• the contractual cash flow characteristics of the financial asset.
The exception to this requirement is where entities apply the option in para. 4.1.5 of IFRS 9,
under which it is possible to designate one or more financial assets as measured at fair value
through P&L. This election is irrevocable and is only applicable when applying the fair value
through P&L eliminates or significantly reduces measurement or recognition inconsistency
(this is sometimes described as an accounting mismatch) that would otherwise arise from
measuring assets and liabilities or recognising gains and losses on different bases.
Paragraph 4.1.2 of IFRS 9 requires entities to measure a financial asset at amortised cost when
both of the following conditions are met:
• The asset is held within a business model whose objective is to hold assets in order to collect
the contractual cash flows.
• The contractual terms of the financial asset give rise (on specified dates) to cash flows that
are solely payments of principal and interest on the principal amount outstanding.
Paragraph 4.1.2A of IFRS 9 states a financial asset is to be measured at fair value through OCI
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when both of the following conditions are met:

1. The asset is held within a business model whose objective is achieved by both collecting
contractual cash flows and selling financial assets.
2. 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.
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The distinction between paras 4.1.2 and 4.1.2A of IFRS 9, and whether a financial asset is
measured at amortised cost or at fair value through OCI, is the entity’s business model for
managing financial assets. An entity’s business model refers to how groups (or portfolios) of
financial assets are managed by an entity to generate cash flows. In particular, the entity’s
business model for a portfolio of financial assets determines whether cash flows generated from
that portfolio will result from collecting contractual cash flows, selling financial assets or both
(paras B4.1.2 and B4.1.2A of IFRS 9). When the objective of the business model is to hold assets
in order to collect contractual cash flows, a financial asset in that portfolio is to be measured at
amortised cost. When the objective of the business model is to both collect contractual cash
flows and sell financial assets, a financial asset in that portfolio is to be measured at fair value
through OCI. Further discussion of an entity’s business model for managing financial assets is
provided below.
Paragraph 4.1.4 of IFRS 9 states that a financial asset will be measured at fair value through P&L in
cases where it does not meet the requirements to be measured at amortised cost or at fair value
though OCI. When an entity has an investment in equity instruments, rather than measuring the
investment at fair value through P&L, the entity can make an irrevocable election when it initially
recognises the investment to present fair value movements in OCI. An entity cannot choose
this option for investments in equity instruments that are held for trading, and it also cannot
be contingent consideration of an acquirer in a business combination to which IFRS 3 applies
(IFRS 9, para. 5.7.5). Business combinations were discussed in Module 5.
Table 6.2 summarises the categories for financial assets under IFRS 9. There is also an option
for entities to apply fair value to one or more financial assets when this would eliminate or
significantly reduce the accounting mismatch (IFRS 9, para. 4.1.5). This decision is made at
initial recognition and is irrevocable.
Table 6.2: Summary of financial asset categories as per IFRS 9 Financial Instruments
classification requirements
Financial asset Classification
Financial assets held within a business model Amortised cost

(whose objective is to hold assets in order to
collect contractual cash flows), and that have
contractual terms that give rise (on specified dates)
to cash flows that are solely payments of principal
and interest on the principal amount
Financial assets held within a business model Fair value through OCI
(whose objective is to both collect contractual
cash flows and sell financial assets), and that have
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contractual terms that give rise (on specified dates)

to cash flows that are solely payments of principal
and interest on the principal amount
All other financial assets (including derivatives) Fair value through P&L
Irrevocable decision for investments in equity Fair value through OCI

instruments to show fair value movements in OCI
Dividends received are recognised in P&L
Source: Adapted from IFRS Foundation 2017, IFRS 9 Financial Instruments,

Business model
The linking of classification with an entity’s business model is consistent with the approach used
by the IASB in other standards, such as IFRS 8 Operating Segments. The term ‘business model’
is not defined in IFRS 9 but it is described in paras B4.1.1 as ‘the business model as
determined by the entity’s key management personnel’.
The key management personnel, as defined in IAS 24 Related Party Disclosures, are the
group members who determine an entity’s business model. The decision is not made on an
instrument-by-instrument basis but at a higher level. However, it is not necessary to make the
decision at the entity level, as it is possible for an entity to hold portfolios of financial assets
with different objectives.
Example 6.9: Multiple business models

The key management personnel of Split Money Maker Ltd (Split) have formulated two business models,
one to hold financial instruments to collect their contractual cash flows (the 'hold' model) and another
to trade financial instruments for speculative, profit-making, purposes (the 'trade’ model). Split holds
investments in government treasury notes under the ‘hold’ model to collect their contractual cash
flows. It also has investments in shares that it actively trades on a regular basis under the ‘trade’
model, trying to make gains from price movements. Each of these models is distinct and the financial
instruments allocated to each model will have different classification options available dependent on
the model used to manage them.
IFRS 9 allows entities to make some sales of financial assets in a portfolio classified as ‘held
with the intention to collect the contractual cash flows’ provided such sales are not a frequent
occurrence and, where they are, that the entity reassesses the classification (para. B4.1.3). IFRS 9
does not define ‘frequent’ or ‘infrequent’. In a similar way, sales may align with the objective
of holding financial assets to collect contractual cash flows if made close to the maturity and
the proceeds from the sales do not differ significantly from the collection of the remaining
contractual cash flows (IFRS 9, para. B4.1.3.).
Contractual cash flows that are solely payments of principal

and interest on the principal amount outstanding
IFRS 9, para. 4.1.3, states that ‘interest is consideration for the time value of money and for the
credit risk associated with the principal amount outstanding during a particular period of time’.
Therefore, where interest represents more than this, the financial asset cannot be measured at
amortised cost.
Paragraph B4.1.9 of IFRS 9 discusses leverage and describes it as a contractual cash flow
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characteristic of some financial assets that increases the variability of the contractual cash flows,
with the result that they do not have the economic characteristics of interest.
Paragraphs B4.1.13 and B4.1.14 of IFRS 9 provide examples of instruments that would meet
the test of contractual cash flows that do represent solely payments of interest and principal,
and others that do not meet the test.
Example 6.10: Contractual cash flows test

1. James and Kellee agree to a variable rate loan of $500 000 to finance the acquisition of a house.
The variable rate of interest is reset each month based on LIBOR (London Interbank Offered Rate).
2. Troy and Megan also agree to a variable rate loan of $500 000 to finance the acquisition of a house.
The variable rate of interest is reset each month based on 1.5 times LIBOR.
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The loan to James and Kellee would satisfy the sole payments of interest and principal test in IFRS 9,
but the loan to Troy and Megan would not. The reset rate of 1.5 times LIBOR introduces leverage and
means the payments Troy and Megan will make on their loan are more than just payment of interest
and principal.
Paragraphs B4.1.10–11 of IFRS 9 discuss the impact of early repayment, extensions to repayment and
changes to the payments during the life of the instrument. In all cases the test to apply is: Do the
payments still represent solely payments of interest and principal before and after the changes to
the conditions?
In respect of contingent payments and repayments of interest and principal, IFRS 9 requires:
(a) the provision is ‘not contingent on future events, other than to protect’ (IFRS 9, para. BC4.183 (a)):
(i) the holder against the credit deterioration of the issuer (e.g. defaults, credit downgrades or
loan covenant violations), or a change in control of the issuer (IFRS 9, para. B4.1.10), or
(ii) the holder or issuer against changes in relevant taxation or law (IFRS 9, para. B4.1.7A and
B4.1.10)
(b) the ‘prepayment amount substantially represents unpaid amounts of principal and interest
on the principal amount outstanding, which may include reasonable additional compensation
for the early termination of the contract’ (IFRS 9, para. B4.1.11(b)).
➤➤Question 6.5
Determine whether the following instruments satisfy the sole payments of interest and principal
requirement in IFRS 9.
(a) A bond that is convertible into shares of the issuer and the return on the bond is linked to
the return on the issuer’s shares.
(b) A variable rate loan where the rate is reset every three months based on movements in the
CPI index.
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Example 6.11: Business model and contractual cash flows test

Entity A must fund a major purchase of machinery ($10m) in four years’ time as part of a capital renewal
program. To fund the program the CFO is considering two approaches to investing the surplus
funds prior to the capital expenditure and seeks your input as financial controller in the accounting
classification for each approach. The approaches are as follows:
1. To invest in 90-day bank bills, which are continuously rolled into new bills until the capital
expenditure funds are required. Some bills may be sold dependent on the timing of the capital
expenditure. However, any gains or losses would be insignificant due to the short-term nature
of the bills.
2. To invest in medium- to long-term bonds so as to optimise interest income, and then sell these
bonds when the capital expenditure funds are required.
As financial controller, you advise that the first approach would be classified as amortised cost as the
contractual cash flows consist of solely interest and principal, and the business objective is solely to
collect interest and principal. It is expected that there may be some sales at the end of the program but
the gains and losses will be insignificant and effectively reflect the proceeds that would approximate
the collection of the remaining contractual cash flows. However, the second approach would cause
the financial asset to be classified as fair value through OCI because, while the contractual cash flows
consist of solely interest and principal, the business objective is to both collect the cash flows and sell
the assets so as to optimise income.
Option to designate a financial asset at fair value through

profit or loss
As discussed earlier, para. 4.1.5 of IFRS 9 allows entities to make an irrevocable decision to
designate a financial asset at fair value through P&L. This designation is conditional on the fact
that it must eliminate or significantly reduce a measurement or recognition inconsistency that
would otherwise arise from measuring assets and liabilities or recognising gains and losses
on different bases. This inconsistency may arise because the current measurement model is
a mixed attribute model, whereby some elements may be measured at cost and others at
fair value. As a result, there may be measurement inconsistency when the assets and liabilities
are closely linked, as they would be for an insurer. In such a case, the entity can elect to use fair
value and avoid the measurement inconsistency, but this is an irrevocable decision.
The designation does not have to be applied to all financial assets but must be applied
consistently each period to those financial assets so designated. It may also be applied to
groups of financial assets, as discussed.
If you wish to explore this topic further you may now read paras 4.1.1–5, B4.1.1–19 and B4.1.27–36
of IFRS 9.
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Classification of financial liabilities

Paragraph 4.2.1 of IFRS 9 requires all financial liabilities to be classified and subsequently
measured at amortised cost, except for:
(a) financial liabilities at fair value through P&L. These liabilities, including derivatives,
are subsequently measured at fair value.
(b) financial liabilities that arise when a transfer of a financial asset (as discussed in Part B)
does not qualify for derecognition, or when the continuing involvement approach applies.
The example in Part B—where the transferor transfers $5 million worth of debtors to
another entity but guarantees the transferee for all losses of bad debts up to $1 million—
gives rise to a financial liability for the transferor of $1 million.
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(c) financial guarantee contracts as defined in Appendix A, which refers to a guarantee

where the guarantor is now required to make payments to the lender based on some
form of default by the original borrower. Such contracts are to be measured—unless (a)
or (b) above apply—at the higher of the amount determined in accordance with IAS 37
Provisions, Contingent Liabilities and Contingent Assets and the amount initially recognised.
(d) commitments to provide a loan at a below-market interest rate. The commitments are
measured—unless (a) above applies—in a similar way to the financial guarantee contracts.
(e) contingent consideration of an acquirer in a business combination to which IFRS 3
Business Combinations applies. Such contingent consideration shall subsequently be
measured at fair value.
Option to designate a financial liability at fair value through

profit or loss
Paragraph 4.2.2(a) of IFRS 9 allows entities to classify a financial liability as at fair value through
P&L where it also eliminates or significantly reduces measurement or recognition inconsistency
that would otherwise arise from measuring assets and liabilities or recognising gains and losses
on different bases. This is consistent with the treatment of financial assets.
Paragraph 4.2.2(b) of IFRS 9 allows the same irrevocable decision to be made where a group
of financial liabilities or financial assets and financial liabilities is managed, and its performance
evaluated on a fair value basis in accordance with documented risk management or investment
strategy. An example would be a superannuation fund or a property trust that holds assets used
entirely to meet the obligations of the entity. Hence, the key management personnel of the entity
use fair values as the only relevant measure, and actively manage its assets and liabilities based
on movements in fair values.
Embedded derivatives
As previously noted, derivatives are classified as at fair value through P&L unless the derivative
is subject to hedge accounting. Classifying a derivative at fair value through P&L means it is
measured at fair value with gains or losses arising from changes in fair value recognised in profit
or loss. Derivatives can also be embedded in financial assets or financial liabilities, as well as non-
financial contracts. Embedded derivatives have specific accounting requirements under IFRS 9.
What is an embedded derivative?

The terminology for assessing the accounting treatment of an embedded derivative is
summarised in Table 6.3. An embedded derivative is a component of a hybrid instrument that
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also includes a non-derivative host contract.
Table 6.3: Embedded derivative terminology
Component Terminology
Derivative Embedded derivative
Non-derivative Host contract
Total Hybrid instrument

Derivatives are highly leveraged financial instruments, changing the risk profile and cash flows of
the entities that use contracts with embedded derivatives. For example, a contract to purchase
a machine in AUD can expose the company to foreign exchange movements if it includes a
rise and fall clause for foreign exchange rates. A host contract can take any form of contract,
including a sale or purchase agreement.
In accordance with IFRS 9, it must be determined whether an embedded derivative needs to

be separated from the host contract and recognised at fair value through P&L.
Do embedded derivatives need to be separated?

Not all embedded derivatives need to be separated from the host contract. Under IFRS 9,
there is no separation of embedded derivatives in financial assets.
The process of identifying embedded derivatives and determining whether they need to be
separated in accordance with para. 4.3.3 of IFRS 9 is determined by the following questions:
• Is the host contract measured at fair value through P&L?
• Does the embedded derivative meet the definition of a derivative on a stand-alone basis?
• Is the embedded derivative clearly and closely related to the host contract?
The process is summarised in Figure 6.1 and described in the following text.
Figure 6.1: Identifying embedded derivatives
2.
3.
1. Does the
No Yes Is the embedded No
Is the host embedded Separate
derivative closely
contract fair derivative meet the accounting
related to the
valued? definition on a
host contract?
stand-alone basis?
Yes No Yes
No separate accounting under IFRS 9 Financial Instruments
Step 1: Is the host contract fair valued?

If a host contract is already classified as at fair value through P&L, there is no need to separate
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the embedded derivative. The value of the embedded derivative will already be reflected in the
value of the host contract.
Step 2: Does the embedded derivative meet the definition on a stand-alone basis?
Does the potential embedded derivative that has been identified meet the definition of a
derivative on its own? For example, a CPI clause in a lease agreement would be regarded as an
embedded derivative because it satisfies the three characteristics of the definition of a derivative
IFRS 9, Appendix A.
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Step 3: Is the embedded derivative closely related to the host contract?

The embedded derivative does not need to be separated when it is closely related to the
host contract. Assessing whether it is closely related requires an analysis of the economic
characteristics and risks of the host contract to determine whether the embedded derivative
changes the nature of the risks involved in the host contract.
If an embedded derivative is not closely related to the host contract, it must be separated
from the host contract and accounted for at fair value through P&L. If the embedded
derivative is separated, the host instrument must also be accounted for in accordance with
the appropriate IFRS.
For example, company Hybrid issues a three-year debt instrument with a principal amount
of $10 000 000 indexed to the share price of Company No-relative, which is a publicly traded
company not related in any way to Hybrid. At maturity, the holder of the instrument will receive
the principal amount (plus any appreciation or minus any depreciation in the fair value of 200 000
shares of Company No-relative) with changes in fair value measured from the date of the
issuance of the debt instrument. No separate interest payments are made. The last sale price
at the issuance date of Company No-relative shares, to which the debt instrument is indexed,
is $50 per share.
The instrument is not itself a derivative because it requires an initial net investment equal to the
notional amount of $10 000 000. The derivative definition in IFRS 9 Appendix A, states that one
of the characteristics of a derivative is that ‘it requires no initial net investment or an initial net
investment that is smaller than would be required for other types of contracts that would be
expected to have a similar response to changes in market factors’.
The host contract is a debt instrument because the instrument has a stated maturity and the issuer
is obligated to pay the holder an amount determined by reference to the share price of Company
No-relative at maturity. Also, the holder has none of the rights of a shareholder, such as the ability
to vote at company annual general meetings or receive dividend distributions to shareholders.
This is similar to issuing a debenture bond.
The embedded derivative is an equity-based derivative that:

• would satisfy the definition of a stand-alone derivative
• is not economically closely related to the debt instrument, and hence must be separated
from the host contract unless the host contract is classified at fair value though profit or loss.
IFRS 9, para. 4.3.5, permits the entire hybrid contract to be accounted for at fair value through
P&L, except where the embedded derivative does not significantly alter cash flows or where it
is clear that the embedded derivative and the host contract are closely related. Where an entity
is required but unable to separate an embedded derivative from its host contract, either at MODULE 6
acquisition or at a subsequent reporting date, it should account for the whole instrument at fair
value through P&L. It would be unusual that the embedded derivative could not be separated,
but this may be the case—for example, where the market for the derivative does not exist,
making it impossible to value the embedded derivative in isolation.
The following example illustrates two embedded derivative scenarios, with one where the
embedded derivative is closely related to the host contract and the other not closely related.
Example 6.12: Examples of embedded derivatives

The Australian Government Department of Defence enters into a contract to purchase military
equipment from a US supplier. The supplier is willing to accept payment in a fixed amount of USD or
the Malaysian ringgit equivalent of the USD amount, and so offers these payment alternatives to the
Australian Government. The government analyses the accounting impact of each payment option
and determines:
1. the fixed payment of USD creates a USD currency derivative, as the amount of Australian currency
required to settle the contract will depend on movements in the AUD/USD exchange rate. In this
case the embedded derivative is closely related to the host contract, as the payment is made in
the functional currency of the supplier and this currency risk is what would normally be expected
when purchasing from a US supplier.
2. the Malaysian ringgit payment option adds a currency which is the functional currency of neither
the buyer nor the seller. Therefore, the embedded derivative would not be closely related to the
host contract and would have to be accounted for separately under IFRS 9. This would mean
carrying the embedded derivative at fair value, taking changes in fair value to P&L.
Reclassification
In IFRS 9, the only circumstances where it is permissible to reclassify a financial asset is where an
entity changes its business model (IFRS9, para. 4.4.1). It is stated that this is expected to be rare,
and para. B4.4.1 of IFRS 9 provides two examples of a change in a business model.
Situations provided in para. B4.4.3 of IFRS 9 that are not examples of a change in a business
model include:
• where an entity transfers financial assets between different portfolios
• where a market for financial assets temporarily disappears
• where an entity changes its intention to hold a financial asset.
Financial liabilities are not permitted to be reclassified in accordance with IFRS 9, para. 4.4.2.
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Summary
Part C discussed the classification of financial assets and financial liabilities. Financial assets are
classified as at amortised cost, fair value through OCI or fair value through P&L. To be classified
as at amortised cost, the financial asset must be held within a business model whose objective is
to hold assets in order to collect contractual cash flows, and the contractual terms of the financial
asset must give rise on specified dates to cash flows that are solely payments of principal and
interest on the principal amount. All other financial assets are classified at fair value. The exception
is where an irrevocable decision is taken to classify a financial asset that would otherwise qualify
for amortised costs, at fair value through P&L due to an accounting mismatch.
Financial liabilities are classified at either amortised cost or fair value through P&L. For a financial
liability to be classified as fair value through P&L, there needs to be an accounting mismatch.
The other categories of financial assets and liabilities are financial guarantee contracts and
commitments to provide a loan at a below market interest rate.
Part C then discussed embedded derivatives and considered the treatment both when the
host contract is, and is not, an asset within the scope of IFRS 9. Part C concluded specifying
that reclassification of financial assets is only permitted when there is a change in the entity’s
business model, and that changes are not permitted for financial liabilities.
Having studied the classification of financial assets and liabilities, Part D now turns to
measurement of financial assets and liabilities, as outlined in IFRS 9.
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Part D: Measurement
Introduction
Part C looked at the classification of financial assets and financial liabilities, which in turn
determines the appropriate measurement method. Part D now considers the measurement
of financial assets, financial liabilities and investments in equity securities, and references the
principles from IFRS 9 where relevant. The specific issue of hedge accounting is considered
in Part E.
Relevant paragraphs
To assist in understanding certain sections in this part, you may be referred to relevant paragraphs
in IFRS 9, IFRS 7 or IAS 32. You may wish to read these paragraphs as directed.
Initial measurement
Paragraph 5.1.1 of IFRS 9 states that all financial assets and financial liabilities should be initially
measured at fair value. For financial instruments that are not measured at fair value through P&L,
the amount shall include transaction costs that are directly attributable to the acquisition or issue
of the financial asset or financial liability. Such transaction costs are added to the fair value for a
financial asset and deducted from the fair value for a financial liability.
‘Fair value’ is defined, in Appendix A of IFRS 9, as the price that would be received to sell an
asset or paid to transfer a liability in an orderly transaction between market participants at the
measurement date. The term ‘fair value’ is also used in other standards, and is a term with which
one should be familiar.
Fair value, including the requirements of IFRS 13 Fair Value Measurement, is discussed in detail in
Module 1. IFRS 13 prescribes a fair value measurement hierarchy, which includes three levels for
inputs to fair value measurement:
• Level 1 inputs refer to quoted prices for identical assets.
• Level 2 inputs refer to inputs where there are no significant unobservable inputs, such as
a quoted price for comparable assets.
• Level 3 inputs refer to valuation models with significant unobservable inputs that must
be estimated.
Paragraph 5.1.1A of IFRS 9 directs readers to para. B5.1.2A for the way to account for any
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financial asset or financial liability that has a fair value different from the transaction price.
Essentially, there are two possible treatments when this arises, as outlined below:
1. Where there are no unobservable inputs in the valuation, such that the fair value is
determined by reference to an active market price for an identical asset or liability (this is a
Level 1 measure of fair value) or another valuation technique that uses observable inputs,
then the difference between the fair value and the transaction price is recognised as a gain
or loss.
2. In all other cases, the difference is deferred and recognised over time based on the change
in a factor such as the unwinding of a discount over time.
If you wish to explore this topic further you may now read paras 5.1.1–1A and B5.1.1–2A of IFRS 9.
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Subsequent measurement of financial assets

The subsequent measurement of financial assets is determined by their classification, which was
discussed in Part C and is summarised in Table 6.2.
Example 6.13: C
alculating the effective interest rate for an
instrument measured at amortised cost
Calculating the effective interest rate of a financial instrument is relatively simple in concept,
but unfortunately there is no simple formula that will calculate it.
Financial calculators, software, and trial and error are the primary methods for calculating the rate.
The rate is simply a discount rate that discounts all future cash flows to the amount of cash received
or paid at the present date.
Consider a bank that lends money and charges an establishment fee. If the bank intends to measure
this instrument at amortised cost, that establishment fee must be recognised as an adjustment to the
effective interest rate of the instrument. If the bank lent JPY 1000 for two years at an interest rate of
2 per cent and charged an additional JPY 10 to establish the loan, the effective interest rate would
solve the following discounting formula:
 1   1   1 
1010 = 20 ×  + 20 × 2
+ 1000 × 2
 1 + RATE   (1 + RATE )   (1 + RATE ) 
Using the original rate of 2 per cent does not work because that discounts to JPY 1000. The discount
rate needs to be decreased in order to increase the present value (PV) of the cash flows. Using a
rate of 1 per cent provides a discounted value of JPY 1020, so clearly 1 per cent is too low. Splitting
the difference between the two rates and using a rate of 1.5 per cent gives a discounted value
that, when rounded up, equals JPY 1010. Using the Goal Seek function in Microsoft Excel (or a
financial calculator) yields an exact rate of 1.49 per cent.
Example 6.14 illustrates how the effective interest rate is used in amortised cost measurement.
If you wish to explore this topic further you may now read paras 5.4.1–3 of IFRS 9.
Impairment of financial assets carried at amortised cost

An asset is impaired when its carrying amount is greater than its recoverable amount. This applies
to both financial and non-financial assets. Impairment losses for non-financial assets are dealt
with in IAS 36 Impairment of Assets (this is discussed in Module 7). For financial assets carried
at amortised cost, an entity recognises impairment for expected credit losses, even if there
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is currently no indication of impairment (IFRS 9, para. 5.5.1).
Impairment of financial assets carried at amortised cost is intended to prevent financial assets
being carried at values that might no longer represent their true value, given changes in
economic factors. Considering that amortised cost financial assets are those the entity intends
to collect cash flows from, it is vitally important that users are able to assess whether those
cash flows will actually flow to the entity. Consider a bank with a large mortgage portfolio.
If a significant portion of that portfolio resided in an economic area experiencing a significant
downturn, the bank might not collect all the cash flows it intended. From a user perspective,
this is reflected through impairment.
Impairment proceeds on a three-stage basis dependent on the credit status of the financial
instrument.
Stage 1––If the credit risk has not increased significantly since initial recognition, then 12 months
of expected credit losses are recognised (IFRS 9, para. 5.5.5). Effective interest is computed on
the gross amortised cost base (IFRS 9, para. 5.4.1).
Stage 2––If the risk of default has significantly increased since the initial recognition, an entity
is required to recognise the ‘lifetime expected credit loss’ on a financial instrument (IFRS 9,
para. 5.5.3). Effective interest is computed on the gross amortised cost base (IFRS 9, para. 5.4.1).
Stage 3––If the financial instrument is ‘credit impaired’, an entity is required to recognise the
‘lifetime expected credit loss’ on a financial instrument. Effective interest is computed net of
impairment losses (IFRS 9, para. 5.4.1b).
Example 6.14: Impairment of a financial asset

An entity has a note receivable and, in June 20X2, it is notified by the issuer that it will only be able to
pay $110 000 at maturity. It is unlikely that the entity will receive any more after this date. The entity’s
initial estimate of 12 months of credit losses is $2000. The following details are available:
$
Issue price of the note on 1.7.20X0 100 000
Maturity value of the note on 30.6.20X3 133 100
No interest is paid on the note. The effective interest rate is the rate that discounts $133 100 in three
years to a PV of $100 000, that is 10 per cent.
The following journal entries are recorded for the note:

Dr Cr
1.7.20X0 $ $
Note receivable 100 000
Cash 100 000
Record the acquisition of the note at cost, being the fair value of purchase consideration (IFRS 9, para. 5.1.1).
This is also equal to $133 100, discounted at the effective interest rate to a PV of $100 000.
Dr Cr
30.6.20X1 (reporting date) $ $
The PV of the note increases to $110 000, which is the PV of $133 100 due in two years. The increase
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represents interest revenue.
Impairment loss 2 000

Provision for expected credit loss 2 000
As credit risk has not increased significantly, under Stage 1 record the 12 months of expected credit losses.
30.6.20X2 (reporting date)

The PV of the note increases to $121 000, which is the PV of $133 100 due in one year.
Provision for expected credit loss 2 000

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Reverse expected credit loss provision as the instrument is in Stage 3, and raise an impairment loss
as shown below.

Provision for impairment 21 000
As the counterparty is ‘credit impaired’ under Stage 3, impairment loss is based on the expected
recovery using the initial discount rate of 10 per cent, based on final expected cash flow of $110 000.
PV at 30 June 20X2 is $100 000.
30.6.20X3 (reporting date)

Cash 110 000
Provision for impairment 21 000
Proceeds are recovered as advised. Impairment loss provision is eliminated and interest is earned at
the effective interest rate at inception.
If you wish to explore this topic further you may now read paras 5.4.1, 5.5.1, 5.5.3 and 5.5.5 and
definition of ‘credit impaired financial asset’ and ‘credit loss’ Appendix A of IFRS 9.
Subsequent measurement of financial liabilities

The subsequent measurement of financial liabilities is also determined by their classification,
which was discussed in Part C and is summarised in Table 6.4.
Table 6.4: Measurement requirements of IFRS 9 Financial Instruments for

financial liabilities
Financial liability Measurement
Financial liabilities Amortised cost
Financial liabilities at fair value through (P&L) Fair value
Financial guarantee contracts Higher of amount determined from applying

the impairment provisions under IFRS 9 and the
amount initially recognised less cumulative income
recognised in accordance with IFRS 15
Loan commitments at below market interest rates Higher of amount determined from the impairment MODULE 6
provisions under IFRS 9 and the amount initially
recognised less cumulative income recognised in
accordance with IFRS 15
Financial liability designated as a hedged item Apply the hedge accounting rules from IFRS 9,
which are covered in Part E
Source: Adapted from IFRS Foundation 2017, IFRS 9 Financial Instruments,

Example 6.15: Amortised cost measurement of a

financial liability
China General Manufacturing Company (CGMC) requires additional funding to expand its product
offerings into Australia. Accordingly, on 1 January 20X3 it obtains a three-year loan of 5 000 000
Chinese Yuan (CNY) at an interest rate of 4.5 per cent. Interest payments are made annually in arrears.
CGMC is required to pay CNY 180 000 to establish the loan, which the bank deducts from the loan
amount advanced.
CGMC measures the loan at amortised cost and notes that the CNY 180 000 establishment fee is an
integral part of the effective interest rate of the loan. CGMC decides to amortise the establishment
fee over the life of the loan and must therefore adjust the 4.5 per cent real interest rate to account
for this additional expenditure.
Using the formula and financial tools as described in Example 6.13, CGMC calculates the effective
interest rate that discounts all future cash flows to the amortised cost of the loan for CNY 4 820 000
(which is the loan amount net of transaction costs in accordance with para. 5.1.1 of IFRS 9) to be
approximately 5.8 per cent. However, for the purposes of the calculations below the unrounded rate
of 5.8429 per cent is used due to its higher accuracy. Candidates are not expected to calculate this
rate in the exam.
The table below summarises the carrying amount of the loan, the interest expense and contractual
repayment amounts for all three years.
Year Opening balance Repayment Interest expense Closing balance
1 4 820 000 (225 000) 281 627 4 876 627
2 4 876 627 (225 000) 284 936 4 936 563
3 4 936 563 (225 000) 288 437 5 000 000
On initial recognition CGMC recognises the cash received (net of the establishment fee) and recognises
a corresponding liability at fair value less the transaction costs.
Dr Cr
CNY CNY
1 January 20X3
Cash 4 820 000
Financial liability 4 820 000
On 31 December 20X3, CGMC calculates the effective interest expense on the loan based on its
amortised cost. This is: 5.8% × 4 820 000 = 281 627. The cash interest payment is based on the stated
interest rate on the loan amount: 4.5% × 5 000 000 = 225 000. The difference of 56 627 is the amortisation
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of the loan establishment fee in year one.

Dr Cr
CNY CNY
31 December 20X3
Cash 225 000
Financial liability 56 627
This process is repeated in the next year, based on the new amortised cost of the loan arising from
the above journal entry: CNY 4 820 000 + 56 627 = 4 876 627.
Dr Cr
CNY CNY
31 December 20X4
Cash 225 000
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In the final year this process is repeated again, but CGMC then repays the principal amount of
CNY 5 000 000.
Dr Cr
CNY CNY
31 December 20X5
Cash 225 000
(To record the interest expense on the loan and amortise the final amount of the establishment fee.)
Financial liability 5 000 000

Cash 5 000 000
(To recognise the repayment of the loan.)
Note that in each year the carrying amount of the loan is gradually increased to the final amount that
will be repayable.
If you wish to explore this topic further you may now read paras 5.3.1–2 of IFRS 9.
Reclassification of financial assets

The requirements for reclassifications of financial assets are straightforward and covered in
paras 5.6.1–3 of IFRS 9. Where an entity satisfies the rule for reclassification—that is, where there
is a new business model—it shall:
• not restate any previously recognised gains and losses
• (where a financial asset is reclassified to fair value) measure fair value at the date of
reclassification and recognise any gain or loss in P&L
• (where a financial asset is reclassified to amortised cost) recognise the fair value at the
reclassification date as the new carrying amount.
Gains and losses

When a financial asset or a financial liability is measured to fair value, the changes in fair value
must be recognised in the accounts. The changes are reported in the P&L for the period in all
cases unless:
• it is part of a hedging relationship, in which case the hedge accounting rules in IFRS 9,
as discussed in Part E are applied to the changes in fair value
• it is a financial asset held within a business model (whose objective is to both collect
contractual cash flows and sell financial assets), and that has contractual terms that give rise
(on specified dates) to cash flows that are solely payments of principal and interest on the
principal amount
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• it is an investment in an equity instrument and the entity has elected the option of reporting
gains and losses in OCI (equity instruments will be discussed in the next part of this section),
or
• it is a financial liability at fair value through P&L, and the gain or loss arises from changes in
the credit risk of the financial liabilities, which must be reported in OCI (this issue is discussed
towards the end of this section).
For financial assets and financial liabilities carried at amortised cost, and which are not part of a
hedging relationship, gains and losses are recognised in the normal manner when the financial
assets and financial liabilities are derecognised or impaired or reclassified in accordance with
para. 5.6.2 of IFRS 9. The amortisation process allows for the recognition of gains and losses
associated with any premium or discount at the date of acquisition.
For financial liabilities and financial assets that are hedged items, hedge accounting (as set out
in IFRS 9) must be used.
If you wish to explore this topic further you may now read paras 5.7.1–4 of IFRS 9. Please now
attempt Question 6.6 to apply your knowledge of this topic.
➤➤Question 6.6
Jolly Frog Ltd (Jolly Frog) has a portfolio of debt securities that it has been carrying at amortised
cost, as it met the rules in IFRS 9 based on its intent to hold the securities and collect the cash
flows over the terms of the debt securities. On 1 April 20X8, Jolly Frog acquired a financial
services section (Tadpole). Tadpole will have responsibility for managing the securities by selling
and buying based on price movements.
Required:
(a) Jolly Frog wants to apply fair value to the securities since the acquisition of Tadpole. Do you
think Jolly Frog meets the requirements in para. 4.4.1 of IFRS 9? Explain your answer.
(b) Assume Jolly Frog meets the requirement to change to fair value. Prepare the journal entry
for reclassification of the securities by Jolly Frog using the following data, explaining your
reasoning. For the purposes of this question the impairment requirements of IFRS 9 do
not apply.
$
Cost of securities at 1 January 20X7 100 000
Recoverable value of securities at
30 June 20X7 90 000
Allowance for impairment loss 10 000
Fair value of securities at
1 April 20X8 115 000
Dr Cr
$ $
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Investments in equity securities

Many entities have investments in other companies that they enter into by acquiring shares in such
companies. Provided the investment is in an equity instrument—as defined in IAS 32, which was
discussed in Part A—then para. 5.7.5 of IFRS 9 is applicable. Paragraph 4.1.4 of IFRS 9 states that
all investments in equity instruments are to be measured at fair value, with no exceptions.
Paragraph 5.7.5 of IFRS 9 allows entities to make an irrevocable election to report subsequent
changes in fair value in OCI for investments in equity securities that are not held for trading.
‘Held for trading’ is defined in IFRS 9, Appendix A ‘Defined terms’, and reflects the concept of
active and frequent buying and selling with the objective of generating a profit from short-term
fluctuations in price or dealer’s margin. This election can be made for each share investment an
entity has and does not have to apply to the entire class of investments in equity securities.
Paragraph B5.2.3 of IFRS 9 indicates that, at times, cost may be an appropriate estimate of
fair value, and this will only apply to unlisted equity securities. Paragraph B5.2.4 of IFRS 9
lists indicators that would suggest that cost is not an appropriate estimate of fair value.
Such conditions include when the investee is performing significantly better or worse than
normal, or when the investee experiences significant internal problems, such as fraud.
If you wish to explore this topic further you may now read paras 5.7.5–6, B5.2.3–6 and B5.7.1
of IFRS 9.
Liabilities designated at fair value through

profit or loss
Paragraph 5.7.7 of IFRS 9 provides the requirements for the treatment of liabilities designated as
at fair value through P&L. Part (a) of the paragraph requires entities to report the change in the
fair value of such liabilities (other than financial guarantees and loan commitments), which are
due to changes in the credit risk of that liability in OCI. Part (b) requires the remaining amount
of the change in fair value to be recognised in P&L.
Hence, it is now necessary to discuss the concept of credit risk. Credit risk is defined in Appendix A
of IFRS 7 as ‘the risk that one party to a financial instrument will cause a financial loss for the other
party by failing to discharge an obligation’. The disclosures about credit risk are covered in Part F.
However, in the context used in IFRS 9, it is not the credit risk of a party but the credit risk of the
financial liability that is the focus. For example, if ABC Ltd issues secured and unsecured debt
instruments, the credit risk of each instrument will be different even though they are issued by MODULE 6
the same entity. The unsecured debt would be a higher credit risk than the secured debt.
Appendix B to IFRS 9 points out that credit risk is different from asset-performance risk (IFRS 9,
para. B5.7.14). It provides an example of a special purpose entity (SPE) that is set up, and the
returns to holders of securities issued by the SPE are based entirely on the cash flows of the SPE’s
underlying assets. When such assets perform poorly, the returns to the SPE investors will decline.
This is due to poor performing assets and not credit risk, and so the entire change of the fair
value of the liability to the SPE investors would be taken to P&L.
Paragraphs B5.7.16–20 of IFRS 9 detail how the credit risk of a financial liability is to be measured
so that an entity is able to separate the fair value changes of a financial liability into an amount
due to credit risk and other factors.
As an exception to the accounting treatment just outlined, if separating the changes in fair value
related to credit risk would create or enlarge an accounting mismatch in the P&L, then the entity
shall present all of the fair value changes in P&L.
For the purposes of this module, the application of measurement rules to a practical example is
not expected.
If you wish to explore this topic further you may now read paras 5.7.7 and B5.7.13–20 of IFRS 9.
Compound financial instruments

Compound financial instruments, which were referred to earlier in this module, consist of both
equity and liability components. An example of a compound financial instrument is a debenture
bond with an option to convert into an ordinary share by the holder, either at a certain date or at
any time up to a certain date. Such an instrument contains a liability component and an equity
component, and is therefore a good example of a compound instrument.
Component parts of a compound financial instrument are separately classified (IAS 32, para. 28).
According to IAS 32, it is more a matter of substance rather than legal form that liabilities and
equity interests are established by one financial instrument rather than two or more separate
instruments (paras 15 and 18).
IAS 32 requires issuers of instruments such as convertible notes to classify the components as a
financial liability (i.e. a contractual arrangement to deliver cash or other financial assets) and as
an equity instrument (i.e. an option to buy shares of the issuer). Once the component parts are
recognised on the statement of financial position, the classification is not revised, irrespective of
the probability of conversion of the right to purchase shares. If a convertible note is converted
into ordinary shares, the equity component established (when the notes were first issued) can be
reclassified so that the amount becomes part of distributable reserves. The liability component is
extinguished with the issue of new shares.
Component parts are accounted for separately since issuing a financial instrument, like a
convertible note, is in substance the same as issuing debt and options to purchase ordinary
shares. For example, imagine that an entity issues two types of notes, each with a face value of
$1000 and an interest rate of 6 per cent, and both maturing at the same time. The only difference
is that one includes an option for the holder to convert the note to ordinary shares in the
company at any time up to the maturity date. Would you pay the same price for both notes?
The note with the option to convert to shares will command a higher price, which demonstrates
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that the option has a value. This is the major argument for the ‘component parts’ accounting
approach for compound financial instruments. As such, most accounting standards require
the issuer to account separately for the component parts of compound financial instruments.
The holder must account for such financial instruments in accordance with IFRS 9, as discussed
earlier in this module under ‘Embedded derivatives’.
IFRS 9 requires separate measurement of the component parts. IAS 32 requires entities to
first measure the value of the liability component, and the difference between the fair value
of the instrument and the liability value is allocated to the equity component. No gain or loss
is recognised at the time of issue. This means that, at inception, the sum of the individual
component values must equal the value of the instrument as a whole.
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Example 6.16: Initial measurement of a compound instrument

An entity issues 1000 convertible instruments on 1 July 20X6, at a face value of $500 per instrument.
The instruments mature in three years and pay 5 per cent interest annually, in arrears. Each instrument
is convertible into 500 equity instruments at maturity, at the option of the holder. If the holder does not
convert the instrument, the entity will redeem it for face value of $500. At the time the instrument is
issued, the prevailing market rate for a similar instrument (without the conversion feature) is 7 per cent.
Applying para. 28 of IAS 32, the entity determines it has issued a compound financial instrument that
has components of both equity and a liability. To split these components, the entity needs to determine
the fair value of the liability component as discounted using the prevailing market rate of interest.
Present value of the debt component

The debt component is comprised of two cash flow streams:
1. repaying the face value of the instrument at the end of three years (the principal)
2. paying the annual interest coupons.
The fair value of the principal is calculated as follows:
 1 
$500 000 ×  3
=
$408 149
 (1 + 0.07) 
The fair value of the coupon interest payments is calculated as follows:
 1   1   1 
$25 000 ×   1
+ 2
+ 3 
=
$65 608
  (1 + 0.07)   (1 + 0.07)   (1 + 0.07)  
Therefore, the total value of the liability component is $408 149 + $65 608 = $473 757.
Value of the equity component

Clearly, the entity received $500 000 when it issued these instruments (1000 instruments at $500 per
instrument = $500 000), but the value of the liability is only $473 757. The difference of $26 243 is the
value of the conversion option, which is classified as equity.
The journal entry to record the issue of the instruments on 1 July 20X6 is:
Dr Cr
$ $
1 July 20X6
Cash 500 000
Equity 26 243
The equity component is never revalued. However, the liability component is subsequently accounted
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for as any other financial liability. Its carrying amount will gradually accrete interest, at the prevailing
market rate, until it reaches its redemption amount of $500 000 at the end of its three-year life.
On maturity, assume all holders convert their instruments into equity. On conversion, the entity
extinguishes the liability with a corresponding issue of new equity.
30 June 20X9
Equity 500 000
If you wish to explore this topic further you may now read paras 28–32, AG30–5 and Illustrative
Example 9 of IAS 32.
Summary
Part D discussed the measurement of financial assets (including impairment), financial liabilities,
investments in equity instruments and compound financial instruments. The measurement of
the financial assets and financial liabilities (upon initial recognition) is at fair value, plus or minus
transaction costs, when the financial asset or liability is not measured at fair value. Subsequent to
acquisition, financial assets and financial liabilities are measured according to their classification,
as discussed in Part C. For financial assets and financial liabilities that are part of a hedging
relationship, the hedge accounting rules in IFRS 9 apply.
The gains and losses from remeasurement to fair value are included in P&L for all financial assets
and liabilities classified as at fair value through P&L, unless:
• the financial asset or liability is part of a hedge
• it is an investment in an equity instrument where the entity has made an irrevocable decision
to classify such gains and losses in OCI, or
• it is a financial liability designated as at fair value through P&L, and the change is due to
credit risk of the financial liability.
Entities have an irrevocable option to elect to report changes in fair value in OCI rather than P&L.
This election is made on each investment.
The fair value changes for financial liabilities designated as at fair value through P&L are reported
in P&L except where a portion of the fair value change is due to changes in the credit risk of
that liability, in which case such gains or losses are reported in OCI. The only exception to this
requirement arises when the reporting of such gains or losses in OCI results in an accounting
mismatch in P&L.
Gains and losses on financial guarantee contract and loan commitments are reported in full
in P&L.
Part E examines the requirements for hedge accounting in accordance with the principles in IFRS 9.
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Part E: Hedge accounting

Introduction
Part E considers the issues in relation to hedge accounting in accordance with IFRS 9.
Hedging is an activity that many organisations undertake. Commodity hedging is prevalent

in many industries, including aviation, construction, transport and financial markets. Where
resources or inputs to processes have volatile pricing, entities seek to reduce their exposure to
that risk. Hedging is not an exercise in speculation, it is the process of strategically minimising
exposure to risk. For this reason, hedge accounting is very prescriptive and closely related with
financial risk management.
Hedging refers to designating a financial instrument as an offset against the change in fair
value or cash flows of a hedged item, or group of items, with similar characteristics in a hedging
relationship. Interest rate and foreign currency risk are two common risks against which entities
may wish to hedge their exposure.
To apply hedge accounting, an entity must comply with the requirements of IFRS, including
compliance with the qualifying criteria in IFRS 9, para. 6.4.1. These criteria impose somewhat
prescriptive documentation obligations on entities in respect of hedging relationships.
In addition, there must be regular effectiveness assessments showing that an effective
hedging relationship continues. These aspects of hedging are discussed later.
For simplicity, this part of the module discusses only simple financial instruments, such as
payables or receivables and forward contracts, when examining hedging by the use of foreign
currency contracts. Most of the principles that need to be applied can be illustrated using
simple forward contracts as examples.
For hedge accounting to be contemplated, both of the following need to occur:

• On designation date there is a qualifying hedged item, hedging instrument and hedge risk.
• An economic relationship between changes in the fair values of the hedge instrument and
the hedged position; that is, it is prospectively assessed as effective.
Relevant paragraphs
To assist in understanding certain sections in this part, you may be referred to paras 6.1.1–2 and 6.4.1
in IFRS 9. You may wish to read these paragraphs as directed.
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Hedging relationships
A hedging relationship is the designated arrangement in which an entity manages risks that
could affect P&L, or, in some cases, OCI.
A hedging relationship requires both:

(a) a hedging instrument
(b) a hedged item—this can be a risk component arising from a risk exposure, the entire risk
exposure, or a group of similar risk exposures.
Hedging instruments
According to paras 6.2.1–2 of IFRS 9, for a financial instrument to be a qualifying hedging
instrument, it must be either:
• a derivative that is measured at fair value through P&L (as discussed in Part D), except for a
written option in some particular circumstances, or
• a non-derivative financial asset or financial liability that is measured at fair value through
P&L, except for a financial liability designated as fair value through P&L, where changes in
fair value attributable to changes in credit risk are presented in OCI (as discussed in Part D).
For a hedge of foreign currency risk, the foreign currency risk component of a non-derivative
financial asset or financial liability may be designated as a hedging instrument, provided it
is not an investment in an equity instrument that the entity has elected to designate as fair
value through OCI (as discussed in Part D)
Derivative instruments are instruments such as interest rate options and futures, currency
swaps, and interest rate swaps. Any of these instruments could be designated as a hedging
instrument, but could equally be carried to collect cash flows or be held for another purpose.
It is the intention of management that, in part, determines whether a financial instrument is to
be regarded as a hedge.
If you wish to explore this topic further you may now read paras 6.2.1–6.2.3 and B6.3.1–6.3.6 of IFRS 9.
Hedged items
A hedged item can be:
• a recognised asset or liability
• an unrecognised firm commitment
• a highly probable forecast transaction, or
• a net investment in a foreign operation.
The hedged item can be either a single item or a group of items (subject to the group of items
meeting specified conditions). A hedged item can also be a component of such an item or group
of items.
If you wish to explore this topic further you may now read paras 6.3.1–6.3.7 of IFRS 9.
Hedging risk components

Paragraph 6.3.7 of IFRS 9 permits the hedging of various financial risks (e.g. foreign exchange,
interest, commodity) or components of them.
Foreign currency risk arises when an entity is committed to pay (receive) units of foreign currency––
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where there will be a loss (or gain) if the reporting currency falls (or rises) relative to the foreign
currency. To protect against exposure to foreign currency losses, an entity may enter into hedging
transactions. These transactions may involve foreign currency contracts (e.g. forward contracts,
hedge contracts, futures contracts or foreign currency options) or other foreign currency
transactions (e.g. investing in a foreign currency physical asset to hedge a long-term foreign
currency liability, or relying on natural hedges such as matching of foreign currency revenue
streams with foreign currency payments).
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For example, an Australian entity sells goods to a customer in Hong Kong, with payment in
Hong Kong dollars (HKDs) in 28 days. The transaction means the Australian entity is exposed to
changes in exchange rates over the 28 days. If the value of the AUD appreciates, the Australian
company receives fewer AUDs, but if the AUD depreciates, the entity receives more AUDs.
The entity can enter a forward exchange contract to sell the HKDs it receives in 28 days. It has
effectively hedged its position. Changes in the value of the forward exchange contract should
effectively offset changes in the value of the underlying receivable.
The designation of risk components of hedged items can only occur if they are separately
identifiable and reliably measurable, irrespective of whether the item that includes the risk
component is a financial or non-financial item. The determination of being able to separately
identify and reliably measure appropriate risk components requires an evaluation of the relevant
facts and circumstances.
Example 6.17: Identifying a risk component

Tokyo Optics has a raw material supply contract with a supplier in Malaysia. The contract contains a
foreign currency exchange clause whereby the Japanese Yen and Malaysian Ringgit exchange rate is
contractually specified and reset to market rates only once every four months.
Tokyo Optics determines that there are a number of risks components associated with this contract.
These risk components are:
(a) foreign currency risk
(b) raw material price risk.
Tokyo Optics concludes that the foreign currency risk is separately identifiable and reliably measurable
because the Japanese Yen and Malaysian Ringgit are liquid currencies in the international market.
However, the specific raw materials that Tokyo Optics uses are highly specialised and are not actively
traded. Therefore, the raw material price risk cannot be identified as a risk component.
➤➤Question 6.7
Should the following be considered hedged items under IFRS 9?
(a) A company has signed a contract to purchase goods from a supplier in South Korea in six
months. The company enters a forward exchange contract to buy wons (the currency of
South Korea) in six months.
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(b) A company has a potential customer located in France who is considering the purchase of one
of its high-powered luxury ferries within the next six months. The company enters a forward
exchange contract to sell euros in six months.
Accounting for hedging relationships

The criteria adopted in IFRS 9 are stated in para. 6.4.1. The criteria include that:
• the ‘relationship consists only of eligible hedging instruments and eligible hedged items’
• there is formal designation and documentation at the inception of the hedging relationship
about the hedging relationship and the entity’s risk management objective and strategy for
undertaking the hedge
• ‘there is an economic relationship between the hedged item and the hedging instrument’
• ‘the effect of credit risk does not dominate the value changes that result from that economic
relationship’
• the hedge ratio of the hedging relationship is the same as the ratio between the hedged item
and the quantity of the hedging instrument that ‘the entity actually uses to hedge that quantity
of hedged item’. However, the hedge ratio cannot be set in such a way that it would give rise
to an accounting outcome that is inconsistent with the purpose of hedge accounting.
The IFRS 9 hedge accounting model employs a principles-based approach that is based on an
entity’s risk management strategy. This means the entity’s financial statements should be more
reflective of the entity’s actual risk management activities. Reflecting the economic substance and
actions of an entity in relation to transactions is one of the primary goals of financial reporting.
If you wish to explore this topic further you may now read paras 6.4.1 and B6.4.1–B6.4.19 of IFRS 9.
MODULE 6
Figure 6.2 summarises the required steps for designating a hedging relationship.
Study guide | 571
Figure 6.2: How to achieve hedge accounting
Define risk management (RM)

strategy and objective
Identify eligible hedged item(s) and

eligible hedging instruments
No Is there an economic relationship between

hedged item and hedging instrument?
Yes
Yes Does the effect of the credit risk

dominate the fair value changes?
No
Base hedge ratio on the actual

quantities used for risk management
Yes Does the hedge ratio reflect an imbalance

To avoid that would create hedge ineffectiveness?
ineffectiveness,
the ratio may have
to differ from
the one used in RM. Formal designation and
documentation
Source: EY 2014, Hedge Accounting under IFRS 9, p. 31, accessed November 2017,
http://www.ey.com/Publication/vwLUAssets/Applying_IFRS:_Hedge_accounting_under_IFRS_9/$File/
Applying_Hedging_Feb2014.pdf.
Types of hedges
Paragraph 6.5.2 of IFRS 9 defines three types of hedges. Regardless of the type of hedge used,
the hedging instrument will always be measured at fair value. Measurement of the hedged item
differs depending on the type of hedge applied. The three hedge types are:
• Fair value hedges: a hedge of the exposure to changes in the fair value of a recognised asset,
liability or an unrecognised firm commitment to buy or sell resources, or to a portion of such
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an asset, liability or firm commitment. There also must be the potential for this risk to affect
profit or loss. For example, the value of a fixed-rate loan increases for the borrower if interest
rates decline. A hedge against this risk is described as a fair value hedge.
• Cash flow hedges: a hedge of the exposure to variability in cash flows that is attributable to
a particular risk with some or all of a recognised asset or liability (such as all or some future
interest payments on a variable rate debt) or a highly probable forecast transaction that could
affect profit or loss.
• Hedges of a net investment in a foreign entity.
Finally, the standard permits a choice when hedging firm commitments for foreign exchange risk.
They may be designated as a fair value or cash flow hedge.
If you wish to explore this topic further you may now read paras 6.5.1–6.5.7 and B6.5.1–B6.5.3
of IFRS 9.
Fair value hedges

Fair value hedge accounting is relatively simple. The hedging instrument is measured at fair value
through P&L and the hedged item must also be measured at fair value through P&L. Therefore,
any mismatch between the fair value movements of the hedged item and hedging instrument is
automatically recognised in P&L. However, if the hedged item is an equity instrument measured
at fair value through OCI (as discussed in Part D), the fair value movement of the hedged item
is also recorded in OCI.
Special hedge accounting treatments are specified for hedges of unrecognised firm commitments
and hedges of financial instruments measured at amortised cost. Those hedging relationships are
slightly more complex and it is not necessary to understand them for the purposes of this module.
The accounting treatment for fair value hedges is specified in IFRS 9, paras 6.5.8 to 6.5.10.
Example 6.18: Fixed-to-floating interest rate swap

Interest rate swaps that convert fixed interest cash flows into variable interest cash flows are commonly
used in fair value hedges. Note that, as discussed later, this type of swap cannot be used in a cash flow
hedge because it does not limit cash flow variability; in fact, it increases cash flow variability.
A bank might issue a new fixed rate loan that it cannot measure at amortised cost because of the
facts and circumstances attached to the loan. Consequently, the bank measures the loan at fair value
through P&L. Being a fixed rate loan measured at fair value, the bank needs to discount all future
cash flows at the prevailing market rate of interest. That market rate of interest fluctuates so, as the
market rate of interest increases, the fair value of the loan decreases, and vice versa. This is illustrated
in the chart below.
Fair value of fixed rate loan compared to new loans

entered into at market rates
y2
y
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Fair value
x2 x Market interest rate
Considering the above chart, when the loan is issued at a market interest rate of ‘x’, there is a
corresponding fair value of ‘y’. If the market rate of interest decreases to x2, the fair value of the loan will
increase to y2. Similarly, if the market rate of interest increases, the fair value of the loan will decrease.
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The fair value of the loan decreases when interest rates rise because other banks could issue new
loans that provide greater interest returns when compared to the fixed rate of the loan discussed
here. Similarly, the fair value of the loan increases when market rates decline, because the fixed rate
loan discussed here provides greater returns than other banks could get using market interest rates.
In light of this fair value volatility, the bank does not want the fair value movements of this loan to
distort the stability of its balance sheet. The bank decides to enter into a fixed-for-floating interest
rate swap with another bank. The terms of the fixed-for-floating swap are such that they perfectly
match those terms of the loan. The fair value movements of this swap would be the exact opposite
to those illustrated in the previous diagram. If the fair value of the loan increased by AUD 100 000,
the fair value of the swap would decrease by AUD 100 000. This is because the entity has entered into
a contract to pay another entity fixed interest cash flows in exchange for variable cash flows. Therefore,
if the entity is paying less in fixed interest payments than it is receiving in variable interest payments
(because market rates are higher than the fixed rate on the loan), the fair value of the swap will be
an asset. Contrast this with the loan where the higher market interest rates cause the fair value of the
loan to decrease.
Fair value of fixed rate loan

Fair value
Fair value of interest rate swap
Market interest rate
Entering into a fair value hedge with this swap allows the bank to reduce the volatility associated with
fair value movements on its balance sheet.
Extension of fair value option

The IFRS 9 hedge accounting model extends the use of the fair value option in two common risk
management activities, to provide an alternative to formal hedge accounting while providing a
similar accounting result. These activities are as follows:
(a) Use of credit derivatives in hedging

When an entity uses a credit derivative, measured at fair value through P&L, to manage
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credit risk of all or a portion of credit exposure on a financial asset or liability, it may designate
all or a portion of the credit exposure at fair value through P&L, provided the name and
seniority of the financial instrument referenced in the credit derivative matches the hedged
credit exposure.
(b) Own-use contracts

Paragraph 2.5 of IFRS 9 permits entities to account for ‘own-use’ contracts (i.e. contracts
to buy or sell non financial items for own use) at fair value through P&L, if it eliminates an
accounting mismatch—as previously covered in Part A under the topic ‘Contracts to buy or
sell non-financial items’.
As an example, a wholesaler of electricity in Australia sells industrial customers fixed-price

electricity contracts for two years. It then buys electricity at spot from the market and hedges
the spot price risk by entering into fixed-price swap contracts with an electricity-generating
company. Economically, this enables the wholesaler to fix its purchase price of electricity and
thus lock in a gross margin. To achieve a smooth accounting result, the company could adopt
formal cash flow hedge accounting for the swap contracts or, as an alternative, could apply the
fair value of own use contracts option to simply measure the customer contracts at fair value.
This latter approach would mean that the fair value changes of the customer’s contracts would
offset the fair value changes of the swap contract in the P&L. The fair value of own-use contracts
may be a simpler accounting approach when the wholesaler manages the customer contracts on
a portfolio approach.
Example 6.19: Hedge against change in fair value

of existing inventory
Company A maintains an inventory of 5000 barrels of oil and wants to hedge the risk of changes in
the price of oil. On 1 July 20X7, Company A purchases a forward derivative instrument to fix the price
of oil at the current price of $40 per barrel. The forward matures on 31 December 20X8. Company A
complies with all of the hedge documentation and effectiveness requirements.
The following table summarises the market data used in the journal entries below. In this case the
cost of purchasing the forward is nil.
Hedged value of
inventory (fair value
Fair value of Fair value of of inventory +
inventory futures contract fair value of contract
Spot price (5000 × spot (5000 × [$40 – + cash from futures
of oil price) spot price]) contract)
Period $ $ $ $
1 July 20X7 40 200 000 0 200 000
31 December 20X7 30 150 000 50 000 200 000
31 December 20X8 25 125 000 75 000 200 000
Dr Cr
$ $
1 July
20X7
(No entry as the fair value of the forward contract is zero.)
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31 December
20X7
Forward derivative contract 50 000
Gain—P&L 50 000
(To record the increase in the fair value of the derivative.)
31 December
20X7
Loss—P&L 50 000
Oil inventory 50 000
(To record the decrease in the fair value of the oil inventory.)
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At 31 December 20X8 the derivative matures and its fair value has increased by $25 000, while the fair
value of the oil inventory has decreased by $25 000.
Dr Cr
$ $
31 December
20X8
Gain—P&L 25 000
(To record the increase in the fair value of the derivative.)
31 December
20X8
Loss—P&L 25 000
Oil inventory 25 000
(To record the decrease in the fair value of the oil inventory.)
31 December
20X8
Cash at bank 75 000
(To record the receipt of payment from the forward derivative contract debtor.)
Note how, at the start of the hedge, Company A had $200 000 of assets. At the end of the hedge
relationship the value of the oil inventory decreased by $75 000, but the entity received that decrease
in cash when the derivative matured. Therefore, the entity still has $200 000 of assets, but it is now a mix
of cash and inventory. Company A has protected itself from the significant decrease in the price of oil
from $40 per barrel to $25 per barrel.
Cash flow hedges

A cash flow hedge is intended to protect an entity against the unfavourable impact on future
cash flows from a change in, say, interest rates or exchange rates. For example, an entity with
a variable rate loan will be required to pay higher interest payments if interest rates increase.
Accordingly, the entity is subject to cash flow risk in the form of higher interest payments from
an increase in interest rates.
Example 6.20: Floating-to-fixed interest rate swap

Consider the same bank as was discussed in Example 6.18, but in this case the bank has issued a
variable rate loan to a customer. The bank notes that the interest receipts (cash flows) associated with
this loan will vary in response to changes in the variable loan rate. MODULE 6
The bank decides to protect itself from that cash flow variability by entering into a floating-for-fixed
interest rate swap. This swap allows the bank to pay floating interest rate payments in exchange for
fixed interest rate payments. The bank sets the terms of the swap to perfectly match those of the loan.
As a result, the bank has effectively converted the variable rate cash flows from the loan into fixed
rate cash flows using the swap.
The accounting for cash flow hedges under IFRS 9, para. 6.5.11, is more complex than fair
value hedges. Unlike a fair value hedge, it is not possible to attribute a fair value to the hedged
item of a cash flow hedge, such as a series of interest payments. Therefore, to account for a
qualifying cash flow hedge under IFRS 9, the changes in the fair value of the hedge instrument
are recognised in OCI and accumulated in an equity reserve (usually referred to as the cash
flow hedge reserve). The amount accumulated in the cash flow hedge reserve is subsequently
removed from equity. IFRS 9 prescribes three different accounting treatments for removing the
amount accumulated in the cash flow hedge reserve depending on the situation, as the following
discussion explains.
In Example 6.20, the fair value gains and losses on the hedging instrument—that is, the interest
rate swap—would be recognised in OCI and accumulated in the cash flow hedge reserve.
The amount accumulated in the cash flow hedge reserve would subsequently be reclassified
to P&L when the interest income is recognised in P&L. Thus, the net effect on P&L is similar to
fixed interest income.
To ensure only legitimate amounts are recorded in the cash flow hedge reserve via OCI, only the
‘effective’ portion of the fair value changes on the cash flow hedging instrument can be deferred
in the hedge reserve. The ‘effective’ component is defined as the lower of (in absolute amounts):
• the cumulative gain or loss on the hedging instrument since inception of the hedge, or
• the cumulative change in fair value on the hedged item from inception of the hedge.
The cumulative change in fair value of the hedged item is computed as the present value of
the cumulative changes in the expected hedged cash flows—for example, the present value
of the cumulative changes in the expected future interest payments that form the hedged
item of the cash flow hedge. Work through Example 6.21 to better understand this calculation.
Also, the ‘effective’ component in a cash flow hedge is determined based on a ‘lower of’
test. This is because it is considered acceptable to be under-hedged in a cash flow hedge,
whereas being over-hedged in a cash flow hedge results in ineffectiveness, which is recognised
immediately in profit or loss. For example, assume that in Example 6.20 the swap’s cumulative
change in fair value is $100 but the cumulative change in the fair value of the hedged item
(calculated as the present value of the cumulative change in interest receipts) is negative $90.
Then the effective portion is $90 and the $10 surplus on the swap’s fair value change is the
ineffective portion, which is recognised in P&L.
The amount accumulated in the cash flow hedge reserve is subsequently removed from equity
in the following three ways:
1. If the cash flow hedge was either a hedge of a forecast transaction (e.g. purchase of
inventory) that results in the recognition of a non-financial asset (e.g. inventory) or liability,
the amount is transferred to the initial cost or other carrying amount of the asset or liability.
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2. The amount is reclassified to P&L in the same period or periods as the cash flows from the
hedged item occur (for cash flow hedges other than those covered by (1)).
3. If the amount in the hedge reserve is a loss and the entity does not expect the loss to be
recovered in the future, then the amount is immediately reclassified to P&L.
An example of (1) is demonstrated in Example 6.21; (2) would be utilised for the fact set in
Example 6.20; and (3) would be a situation where a loss has been deferred on a cash flow hedge
for an inventory purchase, but the ultimate forecast gross margin on the inventory is insufficient
to cover the accumulated loss in the cash flow hedge reserve.
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Example 6.21: Hedge of a purchase of inventory

Because the demand for foreign parts for computer printers was rising rapidly, on 2 May 20X9
Domestic Ltd (Domestic) entered into a non-cancellable purchase commitment for 5000 items to be
shipped on 30 June 20X9. The total price for the shipment was FC 1 000 000, to be paid in FC on the
date of shipment. (FC represents a foreign currency, not specified in the example.)
On 2 May 20X9, Domestic entered into a forward foreign exchange contract to receive FC 1 000 000
from a foreign currency broker on 30 June 20X9, and pay $310 000 to settle the foreign currency contract.
The purpose of the hedge is to fix the amount of cash payable for the inventory at $310 000. The hedging
instrument is designated in its entirety in the hedging relationship. Splitting the forward element of
the forward contract is discussed later.
The company prepares monthly accounts for all foreign currency hedges as cash flow hedges.
Assume the company complies with all of the hedge documentation and effectiveness requirements.
Exchange rates
Forward rate for delivery
Spot rate of FC on 30 June 20X9
2 May FC1 = $0.30 FC1 = $0.31
31 May FC1 = $0.31 FC1 = $0.32
30 June FC1 = $0.33 FC1 = $0.33
Analysis of the economic effects of the hedge transaction and purchase transaction
The economic effects of the hedge can be determined by analysing the exchange differences that result
from the hedge transaction. Please note that this is a simplified calculation for illustrative purposes,
so there has been no discounting involved. In addition, for hedge accounting with forward contracts
there is a choice of including time value or excluding time value; in this example we have included
time value. Finally, when hedging a firm commitment for foreign exchange risk, the company has a
choice to classify the hedge as a cash flow hedge or fair value hedge; in this example the company
has elected to classify the hedge as a cash flow hedge.
Foreign currency payable (hedged item)
Expected Movement
Fwd rate cash flows gain/(loss)
2 May FC1 = $0.31 310 000 —
31 May FC1 = $0.32 320 000 (10 000 )
30 June FC1 = $0.33 330 000   (10 000 )
Total   (20 000 )
The expected cash flows of the purchase of inventory is based on the forward exchange rate at
inception. Hence, at the inception of the hedge, it was expected that the purchase would cost $310 000.
At 31 May the cumulative change in the expected cash flow of the hedged item was negative $10 000 MODULE 6
because the forward exchange rate at 31 May to 30 June had changed to FC1 = $0.32.
FC forward contract (hedge instrument)
Forward Forward
rate for contract
delivery Forward (AUD
of FC on contract payable)
30 June (FC units FC1 = Forward
20X9 receivable) $0.31 gain/(loss)
2 May FC1=$0.31 310 000 310 000 —
31 May FC1=$0.32 320 000 310 000 10 000 †
30 June FC1=$0.33 330 000 310 000   10 000 ‡
Total movement   20 000
†
Calculated as $320 000 – $310 000 = $10 000.
‡
Calculated as $330 000 – $310 000 – 10 000 (already recognised) = $10 000.
The fair value movements in the FC forward contract reflect the change in forward rate for delivery of
FC on 30 June. For example, if Domestic had entered into the forward exchange contract on 31 May
rather than 2 May, the forward rate ‘locked in’ for the delivery of FC on 30 June would have been
FC1 = $0.32. That is, the entity would have paid a total of $320 000 instead of $310 000. The entity
would have paid an additional $10 000 ($320 000 – $310 000) on 31 May, as compared to the actual
forward rate locked in on 2 May. Therefore, as the forward contract is a financial asset (from Domestic’s
perspective), it recognises a gain on the contract at 31 May.
The table below summarises the movements in the hedged item and the hedging instrument.
Movement Movement
in the in the
hedged hedging
item (firm instrument
commitment) (forward Net
FC contract) movement
$ $ $
2 May — — —
31 May (10 000) 10 000 —
30 June (10 000) 10 000 —
Notice that at the end of the hedging relationship the amount of AUD to pay for the inventory would
be $330 000 (FC 1 000 000 × $0.33 spot rate). However, the forward contract is in a receivable position
of $20 000. Consequently, Domestic pays $330 000 for the inventory and receives $20 000 from the
broker. Domestic’s overall cost of the inventory was $310 000, the amount it locked in on 2 May 20X9.
This outcome is what hedging aims to achieve—the minimisation of risk.
This hedge, as with all hedges, has two sides: an obligation to make a payment to the broker, and a
receivable from the broker.
In this example, the obligation is to pay an agreed number of dollars. It remains fixed at the agreed
number of dollars and its measurement is not affected by changes in the exchange rate. In this
case, the receivable is the right to receive a fixed number of FC units. This receivable will change in
accordance with IAS 21 as the exchange rate varies.
The journal entries will reflect the sequence of the underlying economic events (and requirements of
IFRS 9) as follows:
Date Event Entry

2 May Signing of forward contract 1
31 May Remeasure FC forward contract 2
30 June Settlement of FC contract 3

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Receipt of inventory 4
Transfer from equity 5
Journal entries
On 2 May, the forward foreign exchange contract with the broker is signed. This establishes the right
to receive foreign currency from the foreign currency broker on 30 June 20X9 (to enable settlement
of the foreign currency trade payable on the same date) and the obligation to pay the broker at a
fixed forward rate of $0.31 for FC.
2 May Entry (1): Forward contract signed
No entry is required, as the right to receive foreign currency is equal to the obligation to pay the
broker. That is, the fair value of the forward contract on initial recognition is zero.
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31 May Entry (2): Remeasure FC forward contract

Dr Cr
$ $
FC forward contract 10 000
Cash flow hedge reserve 10 000
(To restate $ equivalent of receivable
from broker. The change is recognised as other
comprehensive income and accumulates in equity.)
The fair value of the forward contract has increased by $10 000 and the expected cash flows of the
hedged item have decreased by $10 000. Therefore, the entire change in the forward contract is
considered effective and included in the cash flow hedge reserve.
30 June Entry (3): Settlement of FC contract (net basis)

Dr Cr
$ $
Cash 20 000
FC forward contract 10 000
(To record settlement of the FC forward contract
And recognise its increase in value from 31 May.)
Entry (4): Receipt of inventory

Inventory 330 000
Cash 330 000
(Acquisition of inventory recorded
At purchase price (FC 1m × $0.33).)
Entry (5): Transfer from equity

Inventory 20 000
(To restate $ cost of inventory and transfer
amount previously recognised as OCI from equity.)
As can be seen from the preceding journal entries, the purchase of the inventory is recorded at $310 000
($330 000 – $20 000). This is the purchase of inventory at the spot rate on 30 June, adjusted for the
gains on the cash flow hedge previously recognised in OCI and deferred in the cash flow hedge
reserve (part of equity).
The cash at bank would need to be used to acquire FC 1m at the spot rate on 30 June, which would
then be used to pay the FC payable of $330 000.
Before leaving this example, confirm that the net amount of cash paid ($330 000 – $20 000 = $310 000)
to purchase the inventory is equal to the forward rate at the date of entering the hedge (FC 1m × $0.31). MODULE 6
Therefore, the cash flow hedge was effective in fixing the amount of cash to be paid for the purchase
of inventory.
Foreign currency denominated liability, which hedges an entity’s net investment

in a foreign operation
A net investment in a foreign entity is defined in IAS 21 The Effects of Changes in Foreign
Exchange Rates. An entity may decide to hedge against untoward exchange differences
stemming from its net investment in a foreign operation. One form that a hedge could take
is a foreign currency denominated liability to offset the foreign currency denominated asset
(investment). As the exchange rate fluctuates, the gain (or loss) on the asset will be offset by
the loss (or gain) on the liability.
IFRS 9, para. 6.5.13, states that hedges of an entity’s net investment are accounted for in a similar
manner to cash flow hedges. So, the portion considered to be an effective hedge is included
in OCI, and the ineffective portion is recognised in P&L. This accounting only occurs at the
consolidated level.
The cumulative amount recognised in equity (foreign currency translation reserve) is reclassified
to P&L on the disposal or part disposal of the foreign operation. Accounting for a disposal or part
disposal of a foreign operation, in accordance with IAS 21, was addressed in Module 2.
Special accounting rules

Accounting for the time value of options
Option pricing is an incredibly complex area of finance. For the purposes of this discussion,
however, it is sufficient to understand that an option’s price is made up of two components:
(a) an intrinsic value—this is the difference between the current spot price of the option’s
underlying item and the strike price in the option
(b) the time value of the option—this component broadly reflects the amount of time remaining
until the option’s expiry and the probability of the option expiring on favourable terms.
An option’s time value gradually decreases as the option approaches its exercise date.
This decline in time value appears visually similar to the convergence of spot and forward
rates shown in Part A.
Paragraph 6.2.4 of IFRS 9 permits an entity to designate only the changes in the intrinsic value
of the option in a hedging relationship.
IFRS 9, para. 6.5.15, permits the time value component of an option to be accounted for as
a cost of hedging, depending on whether the hedged item is transaction based (e.g. a hedge
of a forecast transaction) or time-period–based (e.g. a hedge of interest rate risk on a
three‑year loan).
Where the hedged item is ‘transaction related’ (e.g. sales), the time value of the hedging
instrument (e.g. foreign exchange option) is reversed from equity at the same time as the
transaction is recognised. The reversal may be to P&L, or as an adjustment to the carrying
value of the hedged item.
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For a hedged item that is ‘time period related’ (e.g. debt), the time value of the hedging
instrument (e.g. an interest rate cap) is reversed over the same period as those of the hedged
item, specifically the period when cash flows from the hedged item affect P&L. This is usually
done on a straight-line basis.
Amortisation of forward element of forward contracts

Similar to accounting for the time value of options, IFRS 9, para. 6.5.16, allows the recognition of
the forward element of a forward contract, that existed at inception of a hedging relationship,
to be accounted in the same way as the time component of option contracts.
In Part A, the difference between the forward price and the spot price was illustrated. That
difference is referred to as the forward element of the forward contract and, similar to the time
value of an option, this gradually declines as the forward contract approaches maturity.
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Spreads
Basis spreads are charged in cross-currency swaps as a way of balancing the supply and demand
of currencies. IFRS 9, para. 6.5.16, specifically allows foreign currency basis spread in foreign
currency derivatives to be treated similarly to the forward element in a forward contract.
Derivatives may be included as part of the hedged item

Economic exposures frequently have more than one risk—for example, crude oil has commodity
price risk and foreign currency risk. Even though these two risks can be managed together,
entities often use different risk management strategies for the commodity price risk and the
foreign currency risk. IFRS 9, para. 6.3.4, permits a derivative to be aggregated together with
the non-derivative hedged item. This creates a new qualifying hedged item referred to as an
‘aggregated exposure’. Consider an exporter of crude oil: under IFRS 9, an entity is able to
hedge the aggregated USD exposure created by the forecast sale of oil, as well as a derivative
taken out to fix the price of the crude oil.
Assessing hedge effectiveness

Under IFRS 9, a hedge is considered to be an effective hedge when:
• there is ‘an economic relationship between the hedged item and the hedging instrument’.
That is, the hedging instrument and the hedged item have values that generally move in the
opposite direction because of the same risk, which is the hedged risk
• the ‘effect of credit risk does not dominate the value changes that result from the economic
relationship’
• the ‘hedge ratio of the hedging relationship is the same as that resulting from the quantity of
the hedged item that the entity actually hedges and the quantity of the hedging instrument
that the entity actually uses to hedge that quantity of hedged item.’ There is an exception in
that the designation should not ‘reflect an imbalance between the weightings of the hedged
item and the hedging instrument that would create hedge ineffectiveness (irrespective
of whether recognised or not) that could result in an accounting outcome that would be
inconsistent with the purpose of hedge accounting’ (IFRS 9, para. 6.4.1(c)).
It is a requirement that the hedge is effective at designation and thereafter. At a minimum,

the assessment must occur at the earlier of (a) each reporting date, or (b) a significant change
in circumstances that affects the hedge effectiveness requirements.
Hedges are not likely to be perfect in that there will not usually be a 100 per cent offset between
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the hedged item and the hedging instrument. While IFRS 9 does not specify a means of
measurement, hedge effectiveness is typically determined on an objectives-based test that
focuses on the economic relationship between the hedged item and hedging instrument,
and the effect of credit risk on that economic relationship. Furthermore, entities are required
to state what they consider an effective hedge to be, and this needs to be aligned with the
economic realities of the hedge relationship and approved treasury policy/strategy.
If you wish to explore this topic further you may now read paras 6.4.1 and B6.4.1–B6.4.19 of IFRS 9.
Discontinuing hedge relationships

Under IFRS 9, a hedging relationship is discontinued when:
1. the hedging instrument expires, is sold or terminated, or
2. the forecast cash flow hedge is no longer expected to occur.
However, an organisation cannot voluntarily de-designate a hedge relationship (as outlined

in item 2).
If cash flow hedge accounting is discontinued, the amount accumulated in the cash flow
hedge reserve:
• remains in equity if the hedged future cash flows are still expected to occur, or
• is reclassified to P&L if the hedged cash flows are no longer expected to occur (IFRS 9,
para. 6.5.6).
Increased disclosures
Along with the changes in IFRS 9, IFRS 7 disclosures have been modified to require disclosures
of information on risk exposures being hedged, and for which hedge accounting is applied.
Specific disclosures will include:
• a description of the risk management strategy
• the cash flows from hedging activities
• the impact that hedge accounting will have on the financial statements.
These are discussed in more detail in Part F.
Summary
IFRS 9 permits the use of hedge accounting when a hedge instrument is an effective hedge
of a hedged item. This gives rise to the concept of hedge accounting, where the principle is
to recognise the changes in the fair value of hedge instruments in the same period in which
the changes in the fair value of the hedged position are recognised. IFRS 9 identifies fair value
hedges, cash flow hedges and hedges of a net investment in a foreign entity. Gains and losses on
fair value hedges are reported in P&L. Gains and losses on effective cash flow hedges are initially
recognised in OCI, then later reclassified from equity and reported in P&L when the hedged item
is sold, terminated or expired. The concept of matching underlies hedge accounting.
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Study guide | 583
Part F: Disclosure issues

Introduction
The initial approach of most standard-setting bodies to the perceived problems and risks
associated with financial instruments was to require more disclosure. This approach can be
supported on the basis of market efficiency, which suggests that, where information is disclosed,
the market will adjust regardless of how the information is disclosed. Yet, it can be argued that
accountants have a professional responsibility to resolve the recognition and measurement
problems associated with financial instruments.
IAS 32 Financial Instruments: Disclosure and Presentation was first issued in 1995 and was revised
twice before being renamed in 2005 as IAS 32 Financial Instruments: Presentation, following the
publication of IFRS 7 Financial Instruments: Disclosures. IFRS 7 also replaces IAS 30 Disclosures in
the Financial Statements of Banks and Similar Financial Institutions. IFRS 9 covers the recognition,
derecognition, classification and measurement issues as discussed earlier in this module.
IFRS 7 contains detailed disclosure requirements that apply to all financial instruments, not
just derivatives. With the introduction of IFRS 9, the disclosures in IFRS 7 were enhanced to
complement the improvements in the accounting for financial instruments. This section is based
on the disclosures required, assuming IFRS 9 has been fully adopted. Directors and accountants
have been sued in the past for not correctly disclosing the risks of financial instruments and so
careful attention to the relevant disclosures is warranted.
Relevant paragraphs
To assist in understanding certain sections in this part, you may be referred to the relevant
paragraphs in IFRS 7.
Scope and level of disclosure

The risks businesses are subject to are generally categorised as either business risk or financial
risk. Financial instruments are used by many entities to help manage some of these risks, yet also
have the potential to create risks for the entity. Some commentators argue that this was a
contributing factor to the GFC in 2008.
The types of risk identified, and for which IFRS 7 requires disclosure, relate to all financial MODULE 6
instruments, irrespective of whether they are recognised in the financial statements in accordance
with IFRS 9, as discussed in Part B, or are unrecognised (e.g. some loan commitments).
IFRS 7 does not specify a format of how the information on the types of risk should be presented.
IFRS 7 requires disclosures by class of financial instrument. Entities can group financial instruments
into classes that are appropriate to the nature of the information disclosed and the characteristics
of the instruments. Yet, the application guidance—in para. B2 of IFRS 7—indicates that, as a
minimum, financial assets measured at amortised cost shall be grouped separately from those
measured at fair value. Where the grouping for the disclosure requirements of IFRS 7 differs from
the grouping of such instruments in the statement of financial position, sufficient information
must be provided to allow the two to be reconciled.
Paragraph B3 of IFRS 7, in the application guidance, discusses how much detail an entity should
provide in order to comply with IFRS 7. This requires a balance between providing excessive
disclosures that disguise or bury important information, and aggregating data to the point
where important differences between individual transactions are obscured.
Significance of financial instruments for

financial position and performance
Paragraph 7 of IFRS 7 is very general, as it requires an entity to:
disclose information that enables users of its financial statements to evaluate the significance
of financial instruments for its financial position and performance.

The requirements for disclosures in respect of the statement of financial position are specified in
paras 8–15 and 17–19 of IFRS 7, and include the following:
• Categories of financial assets and financial liabilities

The categories of financial assets and financial liabilities are those used in IFRS 9, which were
discussed in Part C. IFRS 7 requires the carrying amounts for each of the categories for financial
assets and for financial liabilities to be disclosed in the statement of financial position or
the notes.
• Financial assets at fair value through profit or loss (recall that this is one of the groups
of financial assets for measurement purposes in IFRS 9)
Paragraph 9 of IFRS 7 requires specific disclosures about any financial asset (or group of
financial assets) that an entity has designated at fair value through P&L. First, an entity must
disclose the maximum exposure to credit risk of the financial asset, and the extent to which
credit derivatives, if any, mitigate this exposure. Second, para. 9 also requires an entity to
provide information about the amount of change in the fair value (both during the period
and cumulatively) of the financial asset that is due to a change in credit risk, as distinct from
changes that are due to changes in market conditions (e.g. changes in interest or exchange
rates). Finally, an entity must disclose the change in fair value of any mitigating credit
derivative that has occurred during the period and cumulatively since the financial asset
was designated.
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• Financial liabilities at fair value through profit or loss

Paragraphs 10, 10A and 11 of IFRS 7 require various disclosures concerning financial liabilities
designated as at fair value through P&L.
Where an entity has to report changes in fair value in OCI attributable to credit risk changes,
an entity is required to disclose:
–– the cumulative amount of the fair value changes that are attributable to changes in the
credit risk of that liability
–– the ‘difference between the financial liability’s carrying amount and the amount the entity
would be contractually required to pay at maturity to the holder of the obligation’
–– ‘any transfers of the cumulative gain or loss within equity during the period, including the
reason for such transfers’
–– if a liability is derecognised during the period, the amount in OCI that was realised at that
time (IFRS 7, para. 10(a)–(d)).
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Where all the changes in fair value are reported in P&L, an entity must disclose changes
for the period plus the cumulative changes. The carrying amount and amount to settle the
financial liability must also be disclosed.
Paragraph 11 of IFRS 7 requires various disclosures about the methodology used to comply
with the requirements in IFRS 9 in relation to this issue, such as the measurement of gains and
losses attributable to credit risk.
• Investments in equity securities where gains and losses are reported in OCI
Entities must disclose the instruments designated at fair value through OCI, the reason
for using this category, the fair value at the end of the period and any dividends received
during the period (IFRS 7, para. 11A). They must also disclose when they sell such securities,
reasons for the sale, fair value at the date of sale and the cumulative gain/loss at the time of
sale (IFRS 7, para. 11B).
If you wish to explore this topic further you may now read paras 8–11B of IFRS 7.
• Reclassification
If any financial asset is reclassified in accordance with IFRS 9, para. 12B of IFRS 7 requires
disclosure of the date of reclassification, and of the amount reclassified together with
an explanation of the change in the business model. The intent here is to ensure that
entities do not use the option to swap categories in order to achieve a better accounting
outcome. This disclosure alerts users to, and may discourage the entity from pursuing,
this possible strategy.
Paragraph 12C of IFRS 9 requires entities to disclose (for financial assets reclassified to
amortised costs) the effective interest rate and the interest income or expense from the date
of the reclassification until it is derecognised. For financial assets reclassified into amortised
cost since the last reporting period, an entity must disclose the fair value at the time of
reclassification and the amount of fair value gain or loss that would have been recognised
had the financial asset remained at fair value through P&L category (IFRS 7, para. 12D).
This enables users to assess the impact of the reclassification on financial performance.
• Offsetting financial assets and financial liabilities

Paragraphs 13A–F of IFRS 7 include disclosures that supplement the other disclosure
requirements of IFRS 7 and are required for all recognised financial instruments that are
set off in accordance with para. 42 of IAS 32. The disclosures also apply to recognised
financial instruments that are subject to an enforceable master netting arrangement
or similar agreement, irrespective of whether they are set off in accordance with
para. 42 of IAS 32.
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Master netting arrangements occur when an entity enters into an agreement with a
counterparty that, in the event of default by the counterparty, allows the entity to offset
all amounts with the counterparty and settle the net amount outstanding. Such arrangements
reduce the credit risk as they do not generally result in an offset of balance sheet assets
and liabilities, as transactions are usually settled on a gross basis. Banks commonly use
such arrangements to reduce their credit risk, as illustrated in an extract of NAB’s financial
statements below.
The Group further restricts its exposure to credit losses by entering into master netting
arrangements with counterparties with which it undertakes a significant volume of
transactions. Master netting arrangements do not generally result in an offset of
balance sheet assets and liabilities, as transactions are usually settled on a gross basis.
However, the credit risk associated with favourable contracts is reduced by a master
netting arrangement to the extent that if a counterparty failed to meet its obligations
in accordance with agreed terms, all amounts with the counterparty are terminated and
settled on a net basis (NAB 2012, p. 122).
The disclosures listed in para. 13C of IFRS 7 are intended to assist the users of financial
statements in assessing the impact of such potential offsetting arrangements on the financial
position of the entity.
Collateral
Paragraphs 14 and 15 of IFRS 7 require disclosures in respect of the carrying amount of financial
assets it has pledged as collateral, including amounts that have been reclassified in accordance
with para. 3.2.23(a) in IFRS 9 and the terms and conditions. Where an entity holds collateral and
is permitted to sell or repledge the collateral, it must provide details about the fair value of such
collateral—including the fair value of any sold or repledged—and the terms and conditions.
Compound financial instruments with multiple embedded derivatives

Disclosure of any such instruments the entity may have is required.
Defaults and breaches

Paragraphs 18 and 19 of IFRS 7 require entities to disclose details of any defaults or breaches of
loans payable during the period. This includes details of where the default was remedied by a
renegotiation of the loan payable before the financial statements were authorised for issue.
If you wish to explore this topic further you may now read paras 12B–15 and 17–19 of IFRS 7.
Statement of profit or loss and other

The requirements for disclosures in respect of the P&L and OCI are specified in IFRS 7, para. 20,
and require entities to disclose certain information about the following items of income,
expense, gains or losses:
• Net gains or losses on financial assets or financial liabilities measured at fair value through
P&L, showing separately those:
–– designated as such upon initial recognition or subsequently in accordance with
para. 6.7.1 of IFRS 9
–– mandatorily measured at fair value in accordance with IFRS 9.
• Net gains or losses on financial liabilities measured at fair value through P&L:
–– IFRS 7 requires the amounts recognised in OCI to be disclosed separately from
amounts recognised in P&L.
• Net gains or losses on financial assets or financial liabilities measured at amortised cost.
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• Net gains or losses on financial assets measured at fair value through OCI.
• Total interest income and total interest expense for financial assets or financial liabilities that
are not at fair value through P&L.
• Fee income and expense (except for amounts included in the calculation of the effective
interest rate) from financial assets or financial liabilities that are not at fair value through P&L
or from trust and fiduciary activities. This is an important activity of many financial institutions
and may be a significant source of fee income.
• A separate analysis of the gains and losses arising from the derecognition of financial assets
measured at amortised cost and the reasons for the derecognition.
If you wish to explore this topic further you may now read paras 20 and 20A of IFRS 7.
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Other disclosures
The requirements in this section are provided in paras 21–30 of IFRS 7 and relate to the
following matters.
• A
ccounting policies
An entity must provide a summary of significant accounting policies, the measurement
method(s) used in preparing the financial statements, and any other accounting policies
used that are relevant to understanding the statements (IAS 1, para. 117). This requirement
is quite subjective. For example, imagine an auditor having to make an assessment of an
entity’s compliance with this requirement.
• Hedge accounting
Paragraphs 21A–24F of IFRS 7 require certain disclosures in respect of risk exposures that an
entity hedges and for which it chooses to apply hedge accounting. Given the importance
of hedging and the potential for entities to pursue income-smoothing strategies, IFRS 7
requires substantial details of hedges, including:
–– the risk management strategy and how it is applied
–– how the hedges may affect the amount, timing and uncertainty of future cash flows
–– the impact that hedge accounting has had on the financial statements
–– details of hedging instruments
–– how the entity determines the economic relationship for assessing hedge effectiveness
–– how the entity establishes the hedge ratio and what the sources of hedge
ineffectiveness are
–– the nature of risks being hedged
–– substantial details about cash flow hedges
–– changes in fair values for fair value hedges (for both the hedging instruments and the
hedged items), together with any ineffectiveness of cash flow hedges and hedges of net
investments in foreign operations recognised in P&L.
• Credit exposure
Paragraph 24G of IFRS 7 requires certain disclosures about any financial instruments or part
of financial instruments that are measured at fair value through P&L because the entity uses
a credit derivative to manage the credit risk.

• Fair value
Paragraph 25 of IFRS 7 requires an entity to disclose information about fair value for each
class of financial assets and financial liabilities in a way that permits it to be compared with
its carrying amount.
Paragraph 28 of IFRS 7 deals with the procedure followed where the fair value of a financial
asset or financial liability, as determined by a valuation technique such as net PV, differs from the
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amount paid or received at inception, as described in B5.1.2A(b) of IFRS 9. If this occurs, IFRS 7
requires disclosure of the accounting policy for recognising that difference in P&L, and of the
total amount yet to be recognised in P&L at the beginning and end of the period.
The only exceptions to the requirement to disclose fair values for classes of financial assets and
financial liabilities listed in para. 29 of IFRS 7 are:
• where the carrying amount is a reasonable approximation of fair value—for example,
accounts receivable or payable
• lease liabilities
• for a contract containing a discretionary participation feature (e.g. certain insurance contracts)
if the fair value of that feature cannot be reliably measured.
Paragraph 30 of IFRS 7 requires additional disclosures about the last of these categories, in order
to enable users to form their own judgment about the differences between carrying amounts and
probable fair values.
➤➤Question 6.8
Discuss possible reasons for the required disclosures in para. 28 of IFRS 7.
Nature and extent of risks arising from financial instruments

All businesses are subject to various types of risk that are generally categorised either as business
risk or financial risk. Financial instruments and, in particular, derivative instruments are used by
many entities to help manage some of these risks. Yet, financial instruments can also create
risks for the entity. It is appropriate here to discuss what is meant by the term ‘risk’. While there
is a tendency to think that risk refers to the possibility of a loss, it also includes the possibility
of gains. Hence, there is downside and upside risk. Risk is defined as the degree of variance in a
set of numbers, with a greater degree of variance representing a higher level of risk. Given the
tendency to associate the word ‘risk’ with the potential for loss, perhaps standard setters should
use phrases such as ‘potential losses’ and ‘opportunities’ (Schrand & Elliott 1998, p. 280).
This risk disclosure deals with how well the organisation has established procedures and internal
controls to deal with its transactions involving financial instruments and, in particular, derivatives.
It is important that a business understands the purpose of derivative financial instruments
and that adequate controls are in place to control such transactions. Many of the large and
spectacular losses associated with derivative instruments involved poor operational procedures
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in relation to such instruments.
Metallgesellschaft AG, the fourth-largest company in Germany, incurred huge losses on its oil
trading in the futures market. The company took positions in the futures market such that it was
betting on oil prices increasing and, when they declined, the company suffered huge losses and
almost went into receivership. It adopted unhedged positions and suffered the consequences.
Orange County in the United States also incurred huge losses when its treasurer borrowed
USD 14 billion and started trading in derivative securities. The treasurer gambled that interest
rates would remain stable or fall, but they increased. The losses suffered by the county resulted
in the loss of 3000 jobs. In the aftermath of this fiasco, it was found that the county was in breach
of its legal position when it borrowed such large sums of money and its trading in derivatives may
also have been illegal.
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Barings is probably the most publicised case involving derivatives and huge losses. The rogue
trader, Nick Leeson, who was jailed for fraud, was involved in writing options to raise cash
to service margin calls on futures contracts that he acquired in the hope that the Nikkei 225
stock index would rise. Instead, the index fell and the company faced bankruptcy. The fact that
Leeson was able to carry out his activities for three years before being discovered raised serious
questions about Barings’ internal control procedures (McClintock 1996). In Australia in 2004,
there were $360 million of options trading losses for the National Australia Bank.
Then, in 2007, the subprime mortgage market in the US began to collapse and so started the
GFC. There is no doubt that risks associated with financial products contributed significantly to
the GFC. The G-20 leaders have been proactive in trying to deal with the causes of the GFC
to reduce the chance of it happening again, as indicated through the following extract from the
G-20 Study Group Report on Global Credit Market Disruptions:
There were serious weaknesses in risk management systems, including weaknesses in aggregating
exposures across all business activities, inadequacies in bank stress testing and insufficient
appreciation of the importance of market liquidity risk. Another source of weakness was a
lack of transparency inherent in complex structured finance products, and in the OTC market,
that contributed to market liquidity drying up. The complex nature of structured finance products
also resulted in some investors having an over-reliance on credit ratings instead of undertaking
adequate due diligence. This complexity also meant that exposures to subprime lending
were difficult to determine, which contributed to difficulties in assessing counterparty risks
(G‑20 2008, pp. 4–5).
The G-20 leaders identified a number of recommendations for dealing with regulators and
accounting standards for financial instruments. ‘Regulators and accounting standard setters
should enhance the required disclosure of complex financial instruments by firms to market
participants’ (G-20 2009).
Disclosures that assist users to assess the risks associated with financial instruments involve
statements by the company that outline its objectives for using financial instruments. IFRS 7
requires disclosures about the entity’s objectives in using derivative financial instruments,
as standard-setters consider some disclosure about the entity’s objectives in using derivative
instruments to be important information for the users of general purpose financial statements.
Further, an explicit requirement to disclose the entity’s objectives in using derivative instruments
focuses senior management’s attention on such transactions, which may contribute to more
effective knowledge of and control over derivatives. While some entities make strategic
choices not to hedge foreign exchange risk, it is important that users are made aware of the
specific policy the entity’s management has in respect of managing risks, including maintaining
unhedged foreign exchange exposure.
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However, it is unlikely that such a requirement would have prevented the problems experienced
by NAB or Barings, which also involved a lack of control over certain key individuals. They certainly
would not have prevented the turmoil seen on global financial markets created by the GFC.
An entity is required to disclose information that enables users to evaluate the nature and extent
of risks arising from its financial instruments (IFRS 7, para. 31). Paragraphs 33–42 of IFRS 7 outline
both qualitative and quantitative disclosures which are meant to provide users with information
about the typical (but not necessarily all) risks that arise from financial instruments, and how they
are being managed.
An entity is required to describe its exposure to risk from financial instruments and how the
exposure arises (IFRS 7, para. 33), including a discussion of the entity’s financial management
objectives and policies, its policy for managing risk and the methods used to measure the risk.
It is also necessary to report in each period any changes to the risks or policies used to measure
and manage the risk.
The minimum quantitative disclosures in paras 34 to 42 of IFRS 7 relate to:

• credit risk
• liquidity risk
• market risk.
Paragraph 34 of IFRS 7 requires a summary of the quantitative data about an entity’s exposure
to each type of risk arising from financial instruments. The information shall be based on that
presented to key management personnel, which will include the board of directors and the
CEO. Where this does not capture all material risks, further disclosure is required. If there
are any concentrations of risks not revealed by the preceding disclosures, these must be
separately disclosed.
Credit risk
‘Credit risk’ is defined in Appendix A of IFRS 7 as ‘the risk that one party to a financial instrument
will cause a financial loss for the other party by failing to discharge an obligation’.
Financial assets that are subject to impairment requirements

Given that at least part of the GFC was attributed to the inadequate disclosure of credit
exposures, the objective of these new credit risk disclosures is to enable users to understand
the effect of credit risk on the amount, timing and uncertainty of future cash flows. Accordingly,
the new disclosures are significant and cover credit management practices, quantitative and
qualitative information, and details of the entity’s credit exposure.
Each entity will need to use judgment on how much to disclose, areas of emphasis, the degree
of aggregation or disaggregation as well as any additional information required to assess the
information disclosed. The following is a summary of disclosures.
Credit risk management practices

Paragraphs 35F–G of IFRS 7 require an entity to explain its credit risk management practices,
and how they relate to the recognition and measurement of expected credit losses. Accordingly,
it should disclose information that enables users to understand and evaluate credit risk
management, including:
• how it has determined whether credit risk has increased significantly since initial recognition,
including:
–– whether financial instruments are considered to have low credit risk, and if so, how
–– whether the presumption that financial assets over 30 days past due has been rebutted,
and if so, how (i.e. why it is not being assumed that a significant increase in credit risk has
occurred since initial recognition)
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• the entity’s definition of ‘default’

• how the instruments were grouped if a collective basis was used to measure credit risk
• the entity’s definition of ‘credit-impaired’
• the entity’s ‘write-off’ policy
• the impact of modifications to contractual cash flows on credit risk assessment.
An entity should also explain the inputs, assumptions and estimation techniques used to
generate the impairment amounts for IFRS 9, including:
• the basis of inputs and assumptions and the estimation techniques used to:
–– measure 12-month and lifetime expected credit losses
–– determine whether the credit risk of financial instruments has increased significantly
since initial recognition
–– determine whether a financial asset is ‘credit-impaired’
• how forward-looking information, including macroeconomic data, has been factored
into expected credit losses
• changes in estimation techniques or significant assumptions, and the reasons for these changes.
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Quantitative and qualitative information about amounts arising from expected

credit losses
Under IFRS 7, para. 35H-L, an entity should explain the changes in the loss allowance along with
reasons for the changes, including presenting a reconciliation of the opening balance of the loss
allowance to the closing balance. A table should be prepared for each relevant class of financial
instruments, showing the changes for the period of:
• the loss allowance measured at an amount equal to 12-month expected credit losses
• the loss allowance measured at an amount equal to lifetime expected credit losses.
An explanation should also be provided as to how significant changes in the gross carrying
amount of financial assets contributed to changes in the loss allowance.
In addition, if there were modifications to contractual cash flows on financial assets not
derecognised during the period, there should be disclosure on the impact of these on the
measurement of the credit loss allowance.
To understand the impact of collateral and other credit enhancements on the amounts of expected
credit losses, the following should be disclosed:
• the maximum exposure to credit risk at the end of the reporting period without consideration
of collateral held or other credit enhancements
• a description of the nature and quality of collateral held as security and other credit
enhancements, any changes to the quality of collateral due to changing policies,
and information on losses not recognised due to collateral held
• quantitative information about the collateral held as security and other credit enhancements
on financial assets that are credit-impaired at the reporting date.
For financial assets, the maximum exposure to credit risk is typically the gross carrying amount,
net of any amounts offset in accordance with IAS 32 and any impairment losses recognised in
accordance with IFRS 9 (B9 of IFRS 7).
Finally, any financial assets that were written off during the reporting period and are still subject
to enforcement activity should be disclosed.
Credit risk exposure

Users should be able to assess an entity’s credit risk exposure and understand any significant
credit risk concentrations. Therefore, under IFRS 7, para. 35M, an entity should disclose, by ‘credit
risk rating grades’, the gross carrying amount of financial assets and the exposure to credit risk
on loan commitments and financial guarantee contracts. This information should be provided
accordingly to how the loss allowance is measured:
• 12-month expected credit losses
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• lifetime expected credit losses

• financial assets that were credit-impaired when purchased or originated.
Credit risk rating grades are ratings of credit risk based on the risk of a default occurring.
The credit risk rating grades used should be consistent with how the entity reports credit risk
internally to key management personnel. If, for a class of financial assets, past due data is
the only counterparty information available and this is used to assess whether credit risk has
increased significantly since initial recognition, an analysis by past due status should be provided.
A concentration of credit risk occurs when counterparties (individually or collectively) are

significantly based in a single geographical region, operate in the same industry or have similar
economic characteristics with the result that their default risk would be affected in the same
fashion by changes in economic or other conditions.
Financial assets that are not subject to impairment requirements

Paragraph 36 of IFRS 7 requires the following disclosures about credit risk for financial
instruments that are not subject to the impairment requirements of IFRS 9:
• the maximum credit risk without taking into account any collateral
• a description of any collateral and other credit enhancements.
Example 6.22: Credit exposure

A bank estimates its credit exposure to a company under a derivative contract to be $1 000 000.
The bank is a secured creditor with a fixed charge over assets owned by the company with a current
market value of $1 000 000. Despite the fact that the bank ranks before unsecured creditors in the event
of default and it is likely that most of the assets would be recovered through realisation of the security,
IFRS 7, para. 36, requires the $1 000 000 to be shown as the amount of the bank’s credit exposure.
Collateral and other credit enhancements

Paragraph 38 of IFRS 7 deals with collateral—or other enhancements an entity may have access
to—that reduce the credit risk of some of its financial or non-financial assets. To help users of
financial statements to assess the entity’s exposure to credit risk, the entity must disclose:
• the nature and carrying amount of any assets that it takes possession of during the period,
as a result of having the collateral or credit enhancements, provided that such items meet
the recognition criteria for assets, and
• when such assets are not readily convertible into cash, an entity must disclose its policies
for disposing of such assets or for using them in the entity’s operations.
If you wish to explore this topic further you may now read paras 35A–38 of IFRS 7.
Liquidity risk
‘Liquidity risk’ is defined in Appendix A of IFRS 7 as ‘the risk that an entity will encounter difficulty
in meeting obligations associated with financial liabilities’.
Disclosures on credit risk assist in partially assessing the liquidity risk relating to the prospect of a
counterparty defaulting. Additional disclosures about the location of counterparties and whether
real-time settlements are used would be relevant.
Paragraph 39 of IFRS 7 requires an entity to provide a maturity analysis for financial liabilities that
shows the remaining contractual maturities and a description of how it manages the inherent
liquidity risk.
In its 2014 annual report, BHP Billiton provided the following disclosure in relation to liquidity risk:
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Liquidity risk
The Group’s liquidity risk arises from the possibility that it may not be able to settle or meet its
obligations as they fall due and is managed as part of the portfolio risk management strategy.
Operational, capital and regulatory requirements are considered in the management of liquidity
risk, in conjunction with short- and long-term forecast information.
Additional liquidity risk arises on debt related derivatives due to the possibility that a market
for derivatives might not exist in some circumstances. To counter this risk the Group only uses
derivatives in highly liquid markets.
The Group’s strong credit profile, diversified funding sources and committed credit facilities ensure
that sufficient liquid funds are maintained to meet its daily cash requirements. The Group’s policy
on counterparty credit exposure ensures that only counterparties of a high credit standing are used
for the investment of any excess cash.
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During the year ended 30 June 2014, Moody’s Investors Service made no change to the Group’s
long‑term credit rating of A1 (the short-term credit rating is P-1). Standard & Poor’s made no change
to the Group’s long-term credit rating of A+ (the short-term credit rating is A-1).
There were no defaults on loans payable during the period.
Source: BHP Billiton 2014, Value through Performance: Annual Report 2014, p. 270, accessed
November 2017, http://www.bhpbilliton.com/~/media/bhp/documents/investors/annual-reports/
Details of the Group’s unused credit facilities followed the above note.
The listing of liabilities (and assets) in order of liquidity in the statement of financial position will
assist users in assessing the liquidity position of an entity. If a more accurate assessment of its
liquidity, and hence solvency position, is to be ascertained, however, it is necessary for additional
information to be disclosed about the maturities of the various liabilities (and assets).
While the standard does not mandate the time periods to use, para. B11 of IFRS 7, in the
application guidance, mentions that appropriate time periods may be:
• up to one month
• from one to three months
• from three months to one year
• from one to five years
• from five years and over.
The grouping of liabilities (and assets) into different maturities could be on the basis of either the
normal repayment (collection) period, which is often earlier than the legal repayment (collection)
time stipulated in the contract or agreement. While the use of expected or effective dates
would be more relevant for users of financial statements, as it is based more on what happens
in practice, the use of contractual repayment periods would normally provide more reliable
information. Paragraph 39(a) of IFRS 7 requires the use of contractual dates.
If you wish to explore this topic further you may now read para. 39 of IFRS 7.
Market risk
‘Market risk’ is defined in Appendix A of IFRS 7 as:
the risk that the fair value or future cash flows of a financial instrument will fluctuate because of
changes in market prices. Market risk comprises currency risk, interest rate risk and other price risk.
‘Other price risk’ is also defined in Appendix A of IFRS 7 as:

the risk that the fair value or future cash flows of a financial instrument will fluctuate because of MODULE 6
changes in market prices (other than those arising from interest rate or currency risk), whether those
changes are caused by factors specific to the individual financial instrument or its issuer or factors
affecting all similar financial instruments traded in the market.
Paragraph 40 of IFRS 7 requires the disclosure of a sensitivity analysis for each type of market
risk to which the entity is exposed at balance date, showing how profit or loss and equity would
have been affected by changes in the relevant risk variable considered reasonably possible
at balance date. Such a requirement appears very broad without specific guidelines, but only
requires the use of reasonably possible estimates for interest rates, interest rate risk and
exchange rates for currency risk.
For example, assume that an entity has $1 million in variable rate loans and that, at reporting
date, the interest rate is 8 per cent. This means an interest payment for the year of $80 000.
If, at reporting date, it was reasonable to expect an interest rate rise or fall in the next 12 months
of 10 per cent, interest rates could vary from 7.2 to 8.8 per cent. This would result in interest
payments ranging from $72 000 to $88 000. The impact of this on profit and equity would be an
increase or decrease of $8000. Entities must also disclose the methods and assumptions used
in the sensitivity analysis and any changes since the last period.
BHP Billiton in its Annual Report 2014 provided the following sensitivity analysis to comply with
para. 40 of IFRS 7:
The principal non-functional currencies to which the Group is exposed are the Australian dollar,
Chilean peso and South African rand. Based on the Group’s net financial assets and liabilities as at
30 June 2014, a weakening of the US dollar against these currencies as illustrated in the table
below, with all other variables held constant, would (decrease)/increase profit after taxation and
equity as follows:
2014 2013
US$M US$M
Profit after Profit after

Currency movement taxation Equity taxation Equity
1 cent movement in Australian dollar (31) (31) (27) (27)
10 pesos movement in Chilean peso (3) (3) 1 1
0.2 rand movement in South African rand (3) 1 (2) 3
The Group’s financial asset and liability profile may not remain constant, and therefore these
sensitivities should be used with care.
Source: BHP Billiton 2014, Value through Performance: Annual Report 2014, p. 268, accessed
November 2017, http://www.bhpbilliton.com/~/media/bhp/documents/investors/annual-reports/
Given that the 2014 profit before tax for BHP Billiton was approximately USD 22 billion,
the amounts reported in the sensitivity analysis are immaterial and will have no impact on
a user’s decisions about buying or selling shares in BHP Billiton.
As the appropriate disclosures to assist users in their assessment of market risk are more
problematic than for credit risk, many large organisations now compute a ‘value at risk’ measure.
Where an entity does produce a value at risk that reflects the interdependencies between risk
variables—such as interest rates and exchange rates—and uses it to manage financial risks,
it may use such disclosures to satisfy the requirements of para. 41 of IFRS 7.
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A ‘value at risk’ measure involves an assessment of potential losses for a portfolio of on

statement-of-financial-position positions and off-statement-of-financial-position financial
instrument hedges due to adverse movements in market risk factors over a certain holding
period. It involves assumed changes in market conditions together with probabilities and
calculation of value at risk under differing market conditions. Disclosure of information about
value at risk should be of benefit to users in their assessment of market risk, and this is the reason
IFRS 7 permits such disclosures in place of the sensitivity analysis required in para. 40(a) of IFRS 7.
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As noted in Part B, IFRS 9 provides guidelines on when financial assets can be removed from the
statement of financial position. Paragraphs 42A–H of IFRS 7 require disclosures of transactions
involving the transfer of financial assets that fail the derecognition requirements of IFRS 9.
The two possible types of transactions are:
1. where an entity transfers only part of a financial asset, such as a portion of its receivables
2. where an entity transfers the entire amount of financial assets but maintains a continuing
involvement, such as when an entity transfers all of its receivables but guarantees the acquirer
for a portion of uncollectible accounts.
The purpose of these disclosures is to allow users to be aware of the transfer and the resultant
liabilities that the entity may have assumed as a result of the transfer failing the derecognition test.
An entity shall disclose the amounts of such liabilities and if the entity partially satisfies the
derecognition test, disclosure is required of the amount of assets it continues to recognise and
the total carrying amount of the original assets.
If you wish to explore this topic further you may now read paras 42A–H of IFRS 7. Please now
attempt Question 6.9 to apply your knowledge of this topic.
➤➤Question 6.9
Why are disclosures about transfers of financial assets that fail the derecognition criteria in IFRS 9
important to users of financial statements?
MODULE 6
Summary
Part F examined the issue of relevant disclosures for financial instruments. Under IFRS 7,
entities are required to make extensive disclosures in relation to financial instruments.
These include disclosures about the significance of financial instruments for financial position
and financial performance in respect of the statement of financial position, the P&L and
OCI, and the statement of changes in equity. Additional disclosures about financial instruments
are also required for:
• significant accounting policies
• hedge accounting
• fair value
• credit risk
• liquidity risk
• market risk
• transfers of financial assets.
Review
Module 6 considered many complex and difficult issues. While it is not expected that the
module will provide everything required to be an expert in accounting for financial instruments,
especially for derivative financial instruments, it should provide a basic understanding of
accounting for financial instruments. To this end, Part A examined the characteristics of some
basic derivative financial instruments—namely, forwards, swaps, options and futures contracts.
Part A also considered the distinction between a financial liability and an equity instrument,
concluding that the substance of the instrument, and not its form, should dictate the
appropriate classification. Where there is no present obligation for the issuer of a financial
instrument to sacrifice economic benefits in the future, the instrument should be classified as
equity. Financial instruments that are settled by an issuer issuing its own equity instruments
are classified as a financial liability when the number of ordinary shares to be issued is variable,
and as equity when the number of ordinary shares to be issued is fixed.
Part B of the module then focused on the recognition and derecognition issues associated
with financial instruments and specified in IFRS 9. Moreover, financial assets and financial
liabilities arising from financial instruments are recognised when the entity becomes a party
to the contract. Financial assets should only be derecognised when an entity loses control
of the economic benefits either through the expiry or transfer of the economic benefits.
Financial liabilities should only be derecognised when the obligation is extinguished.
Part C considered the classification of financial assets and financial liabilities. Financial assets are
classified as at amortised cost or fair value. To be classified as at amortised cost, the financial
asset must be held within a business model whose objective is to hold assets in order to collect
contractual cash flows, and the contractual terms of the financial asset give rise on specified
dates to cash flows that are solely payments of principal and interest on the principal amount.
All other financial assets are classified at fair value except where an irrevocable decision is taken
to classify at fair value through P&L due to an accounting mismatch. As discussed in Part B,
financial liabilities are classified at amortised cost, except for liabilities as at fair value through
P&L or financial liabilities that arise when a transfer of a financial asset does not qualify for
derecognition. The other categories are financial guarantee contracts and commitments to
provide a loan at a below-market interest rate. Part C concluded with a discussion on embedded
derivatives, and considered the treatment both when the host contract is, and is not, an asset
within the scope of IFRS 9.
Part D turned to the measurement of financial assets, financial liabilities and investments in equity
instruments. It explained that the measurement of the financial assets and financial liabilities
MODULE 6
upon initial recognition is at fair value plus or minus transaction costs when the financial asset
or liability is not measured at fair value. Subsequent to acquisition, financial assets and financial
liabilities are measured according to their classification as discussed in Part C. For financial assets
and financial liabilities that are part of a hedging relationship, the hedge accounting rules in
IFRS 9 apply.
Turning to subsequent measurement, Part D showed that the gains and losses from remeasurement
to fair value are included in P&L for all financial assets and liabilities classified as at fair value
through P&L except when:
• the financial asset or liability is part of a hedge
• it is an investment in an equity instrument where the entity has made an irrevocable decision
to classify such gains and losses in OCI, or
• it is a financial liability designated as at fair value through P&L and the change is due to
credit risk of the financial liability.
Study guide | 597
Module 6 also explained that entities have an irrevocable option in respect of equity instruments
to elect to report changes in fair value in OCI rather than P&L. This election is made on each
investment. The fair value changes for financial liabilities designated as at fair value through
P&L are reported in P&L except where a portion of the fair value change is due to changes in
the credit risk of that liability, in which case such gains or losses are reported in OCI. The only
exception to this requirement occurs when the reporting of such gains or losses in OCI results
in an accounting mismatch in P&L. Gains and losses on financial guarantee contracts and loan
commitments are reported in full in P&L.
Next was a discussion of hedge accounting in Part E of the module. This part illustrated
that entities are able to designate almost any recognised asset or liability as a hedging
instrument against risks arising from a hedged item. The hedged item can be a recognised
asset or liability, an unrecognised firm commitment, a forecast transaction, or a net investment
in a foreign operation. The hedged item may also be a risk component arising from any of
these elements. Hedging relationships can be either fair value hedges, cash flow hedges or
hedges of a net investment in a foreign operation. All hedges must continue to be effective
on a prospective basis to qualify for hedge accounting. If a hedge is no longer assessed as
effective, hedge accounting must be discontinued.
The final section, Part F, outlined the appropriate disclosures in respect of financial instruments,
including the requirements of IFRS 7. The disclosures about the significance of financial instruments
for financial position and financial performance in respect of the statement of financial position,
the P&L and OCI, and statement of changes in equity are required. Additional disclosures about
financial instruments are also required for:
• significant accounting policies
• risk management
• hedge accounting
• fair value
• credit risk
• market risk
• transfers of financial assets.
This module illustrated the core principles of accounting for financial instruments, which is one of
the more complicated areas of financial reporting. Some of the complexity arises from the need
to understand concepts of finance and valuation. However, these topics can be mastered with
further exposure to them and a desire to learn more.
MODULE 6
MODULE 6
Suggested answers
Suggested answers
Question 6.1
(a) The instrument meets the definition of a financial instrument because it creates a
financial asset for Angel Investor Pty Ltd, and a financial liability (or equity instrument)
of Easy Business Ltd.
(b) The instrument should be classified as an equity instrument because it meets the fixed
for fixed test. That test requires an instrument to be classified as equity if a fixed amount
of cash is settled with a fixed number of equity instruments. In this case, Angel Investor
Pty Ltd is exposed to the share price movements of those 10 000 shares because the total
value of what it receives in settlement of the instrument will depend on the market price of
Easy Business Ltd shares. For example, if the share price is $5, Angel Investor Pty Ltd will
receive shares to the total value of $50 000 (10 000 × $5), but if the share price is only $0.60,
the value of shares received by Angel Investor Pty Ltd would be $6000 (10 000 × $0.60).
Question 6.2 MODULE 6
A forward contract requires an entity to pay a fixed amount of cash in exchange for cash or
another asset. When used to reduce price risk, the forward contract will usually be settled net
in cash. The effect is that the price of the exposure is fixed at the amount agreed in the contract.
The entity would not be able to participate in any favourable price movements.
An option contract, on the other hand, provides the holder the right, but not the obligation,
to settle the contract at the agreed price. A singular option contract on its own can be used
to limit an entity from either favourable or unfavourable price movements. If an entity chooses
to protect itself from unfavourable price movements, it will be exposed to favourable price
movements, and vice versa. For this reason, some entities favour option contracts over forward
contracts because the option contract allows the entity to participate in favourable price
movements but be protected from unfavourable movements. In contrast, forward contracts
protect the entity from all movements, both favourable and unfavourable.

Question 6.3
Has MCL transferred substantially all the risks and rewards of ownership? The repurchase
agreement is part of the total transaction and it means, in substance, that MCL retains
substantially all the risks and rewards of ownership and should not treat the transaction as a sale.
Note: In this suggested answer the interest expense on the loan is recognised when the entity repurchases
the inventory due to the brief period of the loan. In practice, the entity would carry the loan at amortised
cost and recognise interest expense using the effective interest rate.
Therefore, MCL should record the transaction as:

Dr Cr
$ $
Cash at bank 2 000 000
Loan payable 2 000 000
The impact of the repurchase or repayment of the loan will result in an outflow of $2.4 million
and the removal of the loan.

Loan payable 2 000 000
Cash at bank 2 400 000
Question 6.4
(a) Dr Cr
$ $
Paid-up capital 200 000
Gain on settlement 35 000
(b) Paragraph B3.3.3 of IFRS 9 does not permit the derecognition of a financial liability simply
because funds have been transferred to a trust. There must be a legal release of the
obligation for the debtor.
Therefore, the entry would be:

MODULE 6
Receivables from trust 1 000 000

Cash 1 000 000

Question 6.5
(a) A bond that is convertible into shares of the issuer and the return on the bond is linked
to the return on the issuer’s shares:
This is an example of an instrument that has leverage, as the return to the bond holder is
not based on contractual terms that give rise on specified dates to cash flows that are solely
payments of principal and interest on the principal amount. Hence this instrument would be
classified at fair value.
A variable rate loan where the rate is reset every three months based on movements
(b)
in the CPI index:
This instrument is similar to instrument A in para. B4.1.13 in IFRS 9. The instrument does qualify
for amortised cost as the amounts payable on the loan are reset to the CPI index, which will
adjust the interest for movements in inflation and nothing more. If the reset of interest is linked
to some other measure, like the performance of the debtor, then it fails the test as there is no
certainty about the returns.
Question 6.6
(a) Yes, the securities will no longer be managed based on contractual cash flows but will
be managed by Tadpole on a fair value basis and Jolly Frog will be required to apply the
fair value measurement basis.
(b) The journal entry on 1 April 20X8 is:

Dr Cr
$ $
Securities 15 000
Allowance for impairment loss 10 000
P&L 25 000
At the time of the reclassification and change to fair value, the carrying amount of the securities
was $90 000 because an impairment loss had been recognised to reduce the carrying amount
from cost to the recoverable amount. The above entry reverses the allowance for impairment
account and increases the securities account. The gain of $25 000 is the increase from the former
carrying amount of $90 000 to the new carrying amount of $115 000.
MODULE 6

Question 6.7
(a) The contract to purchase goods is a firm commitment and would be a hedged item under
IFRS 9.
(b) Unless the potential transaction is a highly probable forecast transaction, the transaction
would not qualify as a hedged item under IFRS 9, para. 6.3.3, includes a highly probable
forecast transaction as an acceptable hedge item that can be hedged. Therefore, if the sale
to the customer in France was regarded as highly probable, it would be a qualifying hedged
item under IFRS 9.
Question 6.8
The requirements in para. 28 of IFRS 7 are designed to ensure that entities do not exploit
possible differences between the fair value at the date of initial recognition and the amount
that would be determined using a valuation technique. At the very least, this difference must
be reported, allowing users to assess its impact on the entity’s performance for the period.
Question 6.9
Transfers of financial assets that fail IFRS 9’s derecognition criteria are those that create new
liabilities for entities. Users of financial statements need to understand the relationship between
the assets that continue to be recognised and the newly recognised liabilities. These disclosures
will allow users to understand the cash flows of the entity and its financial position.

MODULE 6
References | 603
References
References
G-20 2008, G-20 Study Group on Global Credit Market Disruptions, accessed November 2017,
http://17g20.pa.go.kr/Documents/sg_report_on_global_credit_market_disruptions_071108.pdf.
G-20 2009, Progress Report on the Immediate Actions of the Washington Action Plan, 2 April,
accessed November 2017, http://www.g20.utoronto.ca/2009/2009report0314.pdf.
McClintock, B. 1996, ‘International financial instability and the financial derivatives market’,
Journal of Economic Issues, vol. 30, no. 1, pp. 13–33.
National Australia Bank (NAB) 2011, 2011 Risk & Capital Report, National Australia Bank,
Melbourne.
National Australia Bank (NAB) 2012, Annual Financial Report 2012, National Australia Bank,
Melbourne.
OECD 2013, ‘Collateralised debt obligations (CDOs)’, Glossary of Statistical Terms, accessed
November 2017, http://stats.oecd.org/glossary/detail.asp?ID=6053.
Schrand, C. M. & Elliott, J. A. 1998, ‘Risk and financial reporting: A summary of the discussion
at the 1997, AAA/FASB Conference’, Accounting Horizons, vol. 12, no. 3, pp. 271–82. MODULE 6
Optional reading
Deloitte International 2016, GAAP Holdings Limited: Model Financial Statements for the
Year Ended 31 December 2016 (With Early Adoption of IFRS 9), accessed November 2017,
https://www.iasplus.com/en/publications/global/models-checklists/2016/ifrs-mfs-2016-ifrs-9.
Ernst & Young 2014, Impairment of Financial Instruments under IFRS 9 December 2014,
accessed November 2017, http://www.ey.com/Publication/vwLUAssets/Applying_IFRS:_
Impairment_of_financial_instruments_under_IFRS_9/$FILE/Apply-FI-Dec2014.pdf.
IAS Plus, ‘Heads up—IFRS 9 gets a new hedge accounting model’, accessed November 2017,
http://www.iasplus.com/en/publications/us/heads-up/2013/hedging.
KPMG 2013, First Impressions: IFRS 9 (2013)—Hedge Accounting and Transition, December,
accessed November 2017, https://home.kpmg.com/content/dam/kpmg/pdf/2013/12/First-
Impressions-O-1312-IFRS9-Hedge-accounting-and-transition.pdf.
MODULE 6
FINANCIAL REPORTING
Module 7
IMPAIRMENT OF ASSETS*
* Parts of this module have been adapted from IAS 36 Impairment of Assets.
606 | IMPAIRMENT OF ASSETS
Contents
Preview 609
Introduction
Objectives
Assumed knowledge
Teaching materials
Relevant paragraphs from IAS 36 Impairment of Assets
Part A: Impairment of assets—an overview 612

Introduction 612
Basic principles of impairment of assets 612
Overview of impairment requirements
Why is impairment important for users?
Key definitions
Scope of IAS 36 Impairment of Assets
Identifying assets that may be impaired 615
General requirements for an impairment review
Specific requirements for certain intangible assets and goodwill
Impairment indicators
Summary 622
Part B: Impairment of individual assets

623
Introduction 623
Measurement of recoverable amount 623
Fair value less costs of disposal 626
Value in use 627
Step 1: Estimating expected future cash flows
Step 2: Determining an appropriate discount rate
Recognising and measuring an impairment loss 635
Reversals of impairment losses 636
Summary 637
Part C: Impairment of cash-generating units 638

Introduction 638
Recoverable amount: Individual asset or cash‑generating unit? 638
Identifying cash-generating units 639
Recoverable amount and carrying amount of a cash-generating unit
(impairment of cash‑generating units) 641
Testing cash-generating units with goodwill for impairment
Timing of impairment tests
Allocating goodwill to cash-generating units
Corporate assets
Identifying and allocating an impairment loss for a cash-generating unit
Intangible assets
Reversal of impairment losses
Summary 651
Part D: IAS 36 Impairment of Assets —disclosure

652
Introduction 652
MODULE 7
Disclosures of impairment losses and reversals

Disclosures of estimates used to measure recoverable amounts in
cash-generating units
Summary 653
CONTENTS | 607
Review 654
References 661
Optional reading
MODULE 7
MODULE 7
Study guide | 609
Module 7:
Impairment of assets
Study guide
Preview
Introduction
Module 1 considered the measurement attributes specified in IFRSs for various assets.
The module noted that cost is specified as the relevant measurement attribute at initial
recognition, and that a variety of measurement attributes are specified for the subsequent
measurement of assets, including cost or fair value. Despite these requirements, IAS 36
Impairment of Assets contains the fundamental principle that the carrying amount of an asset
must not exceed its recoverable amount (IAS 36, para. 1). An asset’s recoverable amount is
the higher of an asset’s ‘fair value less costs of disposal and its value in use’ (IAS 36, para. 6).
To ensure that the carrying amount of an asset does not exceed its recoverable amount,
IAS 36 sets out ‘when an entity needs to perform an impairment test, how to perform
it, the recognition of any impairment losses and the related disclosures’ (Ernst & Young
2010). These requirements apply to non-financial assets that are within the scope of IAS 36.
As discussed later in this module, the application of IAS 36 is subject to a significant degree
of professional judgment in many areas (Grant Thornton 2014).
Module 7 contains four parts. Part A provides an overview of IAS 36, including the basic principles
relating to the impairment of assets and how to identify assets that may be impaired. Part B
addresses the impairment of individual assets including, where required, the measurement of
their recoverable amount. Part C considers the impairment of groups of assets, or cash-generating
units (CGUs), including how to identify CGUs and apply the impairment requirements of IAS 36
to CGUs. Finally, in Part D, the disclosure requirements of IAS 36 are considered.
MODULE 7
Objectives
After completing this module, you should be able to:
• explain the key issues in accounting for the impairment of assets;
• identify the types of assets to which IAS 36 applies;
• evaluate whether an impairment test must be undertaken under IAS 36;
• explain and apply the requirements of IAS 36 in relation to:
–– the calculation of recoverable amount;
–– recognising and measuring an impairment loss for an individual asset; and
–– the reversals of impairment losses; and
• explain and apply the requirements of IAS 36 in relation to:
–– the identification of CGUs;
–– recognising and measuring an impairment loss for CGUs and goodwill.
Assumed knowledge
Before you begin your study of this module, it is assumed that you are familiar with:
• the concept of depreciation under IAS 16 Property, Plant and Equipment and amortisation
under IAS 38 Intangible Assets
• the concept and treatment of goodwill under IFRS 3 Business Combinations, as discussed
in Module 5
• basic present value techniques.
Teaching materials
• IAS 38 Intangible Assets
• IFRS 3 Business Combinations
• IFRS 8 Operating Segments
• IFRS 13 Fair Value Measurement
MODULE 7
Study guide | 611
Relevant paragraphs from IAS 36 Impairment of Assets

To assist in achieving the objectives of this module, you may wish to read the following paragraphs
of IAS 36. Where specified, you need to be able to apply these paragraphs as referenced
throughout the module.
Subject paragraphs
Scope 2–5
Definitions 6
Identifying an asset that may be impaired 7–17
Measuring recoverable amount 18–23
Measuring the recoverable amount of an intangible asset
with an indefinite useful life 24
Fair value less costs of disposal 28–9
Value in use 30–57
Recognising and measuring an impairment loss 58–64
CGUs and goodwill 65
Identifying the cash-generating unit to which an asset belongs 66–73
Recoverable amount and carrying amount of a cash-generating unit 74–103
Impairment loss for a cash-generating unit 104–108
Reversing an impairment loss 109–125
Reversing an impairment loss for an individual asset 117–121
Reversing an impairment loss for a cash-generating unit 122–123
Reversing an impairment loss for goodwill 124–125
Disclosure 126–137
Appendix A: Using present value techniques to measure value in use A1–A21
MODULE 7
Part A: Impairment of assets—

an overview
Introduction
Part A provides an overview of the requirements for impairment of assets as set out in IAS 36.
Items considered in this part include the basic principles relating to the impairment of assets,
key terms specified in IAS 36, the scope of IAS 36, and how to identify whether an asset may
be impaired.
Basic principles of impairment of assets

Overview of impairment requirements
As noted earlier, the underlying principle of IAS 36 is that the carrying amount of an asset
(tangible, intangible or goodwill) must not exceed its recoverable amount. An asset’s carrying
amount can be recovered through ongoing use or sale. The definition of recoverable amount,
considered in further detail below, reflects these two ways in which the carrying amount of an
asset can be recovered.
An impairment loss is recognised to the extent that an asset’s carrying amount exceeds its
recoverable amount. An example of how an impairment loss can arise is shown in Figure 7.1.
In this example, an item of high-tech machinery is purchased at the end of Year 1 for $200 000.
At the date of purchase, the carrying amount and recoverable amount of the machine are
equal. The machine is depreciated on a straight-line basis over 10 years. One year from the
date of purchase, the machine has a carrying amount of $180 000 ($200 000 – $20 000). Due to
unexpected advancements in technology, the entity estimates the recoverable amount of
the machine to be $80 000 at this date. The carrying amount of the machine is, therefore,
impaired because its recoverable amount is less than its carrying amount.
Figure 7.1: Carrying amount of the machine versus recoverable amount

$250 000
Carrying amount
$200 000 Recoverable amount
$150 000
$100 000
$50 000
MODULE 7
$0
Year 1 Year 2

Study guide | 613
An impairment loss of $100 000 must be recognised to reduce the carrying amount of the
machine from $180 000 to $80 000, as reflected in the following accounting entry:
Dr Impairment loss (expense) $100 000

Cr Impairment allowance (asset) $100 000
The future annual depreciation charge is subsequently based on the carrying amount of the
machine after recognising the impairment loss: $80 000 / 9 years = $8889 per annum.
Why is impairment important for users?

Users of financial reports—such as existing and potential investors, lenders and other creditors—
are also interested in assessing the impact of IAS 36 on an entity’s financial position and
performance. Key questions for users include:
• If an entity has recognised an impairment loss, what does this indicate about past
management decisions? Did management pay too much for assets or did the cost of
developing an asset (such internally developed computer software) exceed the actual
benefits from the asset?
• What is the impact of an impairment loss on an entity’s key financial ratios (such as the
current ratio, debt–equity ratio or net interest cover ratio), which are important to users
in comparing the financial performance of the entity over time or with its peers?
• What is the impact of an impairment loss on the future earnings of the entity?
• Is the amount of the impairment loss appropriate? Are further impairment losses likely
and, if so, what is their potential financial impact?
• Is the timing of the impairment loss appropriate? Does the reporting of the impairment loss
coincide with the release of other bad news? Or is it management’s attempt to ‘clean up’
the balance sheet (which sometimes occurs when a new management team is appointed)?
Corporate regulators are also important users of financial reports. Despite the increase in
impairment losses being recognised, the Australian Securities and Investments Commission
(ASIC) has reported that compliance with the impairment requirements is still problematic.
ASIC’s review of 31 December 2015 financial reports noted that the largest number of its
enquiries related to asset values and impairment. ASIC’s findings relating to impairment include:
• incorrect determination of the carrying amount of CGUs
• unreasonable cash flows and assumptions
• overstated asset recoverable amounts
• disregard of the monitoring of impairment indicators
• lack of appropriate disclosure (ASIC 2016).
In 2017, ASIC announced that impairment remains an important area of focus, as ASIC continues
to see companies use unrealistic assumptions in testing the value of assets (ASIC 2017).
The significant impact that impairment can have on financial statements is demonstrated
in Example 7.1.
MODULE 7
Example 7.1: W
esfarmers expects significant impairment
losses in its 2016 results
In May 2016, the Australian conglomerate Wesfarmers—which owns retail businesses such as Bunnings
and Target as well as various resources and industrial businesses—announced that its 2016 full-year
financial results were expected to include a number of significant impairment write downs, including:
• $1.1–1.3 billion pre-tax for the Target business, mainly relating to the share of goodwill relating
to Target that arose from the acquisition of the Coles Group. This expected impairment loss is
taken in light of the difficult trading conditions and short-term outlook for the business, as well
as the decision to restructure the business
• $600–850 million pre-tax for the Curragh coal mining business. This expected impairment loss
is attributable to a difficult trading environment, including adverse foreign exchange rate and
export coal price movements.
This example shows that impairment losses can be substantial and not only triggered by the internal
events of an organisation. Entire industries can be exposed to overstated asset values as historic
assumptions are challenged by changing environments.
Source: Adapted from Wesfarmers 2016, ‘Target and Curragh significant items expected in 2016
full-year results’, 25 May, accessed November 2017, http://www.wesfarmers.com.au/util/news-media/
article/2016/05/24/target-and-curragh-significant-items-expected-in-2016-full-year-results.
Key definitions
Paragraph 6 of IAS 36 includes a number of key definitions in relation to impairment, as shown
in Table 7.1.
Table 7.1: Impairment definitions
Carrying amount ‘The amount at which an asset is recognised after deducting any accumulated
depreciation (amortisation) and accumulated impairment losses thereon’
Recoverable amount ‘The higher of its fair value less costs of disposal and its value in use’
of an asset or a CGU
Fair value ‘The price that would be received to sell an asset or paid to transfer a liability
in an orderly transaction between market participants at the measurement
date’ (see IFRS 13 Fair Value Measurement)
Costs of disposal ‘Incremental costs directly attributable to the disposal of an asset or

cash‑generating unit, excluding finance costs and income tax expense’
Value in use ‘The present value of the future cash flows expected to be derived from an
asset or cash-generating unit’
CGU ‘The smallest identifiable group of assets that generates cash inflows that are
largely independent of the cash inflows from other assets or groups of assets’
(discussed in Part C)
Source: Adapted from IFRS Foundation 2017, IAS 36 Impairment of Assets, para. 6,
in 2017 IFRS Standards, IFRS Foundation, London, pp. A1144–5.
MODULE 7
If you wish to explore this topic further you may now read para. 6 of IAS 36.
Study guide | 615
Scope of IAS 36 Impairment of Assets

The impairment requirements of IAS 36 apply to a broad range of non-financial assets, summarised
in Table 7.2. Non-financial assets excluded from the scope of IAS 36 are subject to the measurement
requirements of other IFRSs. In addition, financial assets, such as loans and receivables, are subject
to the measurement requirements of IFRS 9 Financial Instruments.
Table 7.2: Scope of IAS 36 Impairment of Assets
Applies to Does not apply to
All assets, regardless of whether they are: • Inventories

• current or non-current • Assets arising from construction contracts
• tangible or intangible • Deferred tax assets (refer to Module 4)
• measured at cost or revalued amount • Assets arising from employee benefits
(i.e. fair value) unless specifically excluded • Financial assets within the scope of IFRS 9
(refer to Module 6)
Examples of assets IAS 36 applies to include: • Investment property measured at fair value
• property, plant and equipment • Biological assets related to agricultural
• intangible assets (purchased or internally activity that are measured at fair value
generated) and goodwill less costs of disposal
• investments in subsidiaries, associates and • Deferred acquisition costs and intangible
joint ventures assets arising from an insurer’s contractual
• investment property measured at cost rights under insurance contracts within
the scope of IFRS 4 Insurance Contracts
• Non-current assets (or disposal groups)
classified as held for sale under IFRS 5
Non-current Assets Held for Sale and
Discontinued Operations
To explore this topic further, read paras 2–5 of IAS 36.
Identifying assets that may be impaired

General requirements for an impairment review
Estimating the recoverable amount of an asset or group of assets at the end of each reporting
period can be costly and time-consuming. In recognition of this potential burden, IAS 36 adopts
a two-step impairment testing procedure for assets, except for certain intangible assets and
goodwill where specific requirements (discussed shortly) must be applied.
The first step is to determine whether there is any indication that an asset is impaired
(IAS 36, para. 9). There is a range of indicators to consider (refer to the section ‘Impairment
indicators’). If there is an indication of impairment then the second step, which is to formally
estimate the recoverable amount of the asset, must be completed. If no indication of
MODULE 7
impairment exists, then the second step is not required to be completed.
Note that when IAS 36 specifies requirements as to when the recoverable amount must be determined,
or how to measure the recoverable amount, a reference to the term ‘an asset’ applies equally to an
individual asset or CGU (IAS 36, para. 7).

Specific requirements for certain intangible assets and goodwill

This section considers certain requirements of IAS 38 Intangible Assets (IAS 38) to illustrate
the principle that information presented in financial statements should faithfully represent the
information that it purports to represent.
An intangible asset is defined in IAS 38 as ‘an identifiable non-monetary asset without physical
substance’ (para. 8). As explained in para. 9 of IAS 38, entities often expend resources on
the acquisition, development, maintenance or enhancement of intangible resources, such as
brand names, publishing titles, technical knowledge and intellectual property. Paragraph 9 lists
examples of common items that make up intangible resources, including computer software,
patents, copyrights, customer lists and motion picture films.
When should an intangible asset be recognised? IAS 38 distinguishes different means by which
an entity may acquire an intangible asset. The analysis in this module is confined to internally
generated intangible assets, which fall within the scope of paras 51–67 of IAS 38.
Two problems arise in accounting for internally generated intangible assets: (1) identifying when
there is an identifiable asset and (2) reliably determining the cost of the asset. To address these
problems and uphold the qualitative characteristics of information reflected in financial statements,
IAS 38 prescribes requirements and guidance for internally generated assets in addition to the
general requirements it prescribes for the recognition and measurement of intangible assets.
Specifically, para. 63 of IAS 38 does not permit the recognition of internally generated brands,
mastheads, publishing titles, customer lists and similar items. Expenditure on these types of items
must be recognised as an expense.
Why does IAS 38 not permit recognition of the items listed in para. 63 as assets if they
are internally generated? The rationale for this prohibition is that these items cannot be
distinguished from the cost of developing the business as a whole (IAS 38, para. 64). This is
consistent with the qualitative characteristic of ‘faithful representation’ (as described in the
Conceptual Framework, para. QC12) because labelling an item as an intangible asset asserts
that it is an identifiable asset. However, this is questionable and risks errors in the description of
items in financial statements when applied to expenditure—such as advertising a brand—which
cannot be distinguished from developing the business as a whole. For example, if a company
incurs expenditure in advertising its own product lines, is that expenditure for establishing a new
brand, or is it for developing the business as a whole? IAS 38 takes the position that advertising
expenditure that develops a brand name cannot be distinguished from advertising expenditure
that develops the business as a whole; it is therefore not appropriate to recognise an internally
generated brand name as an identifiable asset in the financial statements.
Intangible assets with indefinite useful lives or that are not yet available for use, and goodwill,
are not amortised under IFRSs. As these assets are not amortised, or their future economic
benefits might be subject to greater uncertainty, there is a higher risk that their carrying amount
might be overstated. IAS 36 therefore requires the recoverable amounts of these assets to
be estimated once a year regardless of whether there is an indication of impairment (IAS 36,
para. 10). Table 7.3 summarises the assets to which these additional impairment requirements
apply and the timing of the determination of their recoverable amounts.
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Table 7.3: Assets with additional impairment requirements
Timing of recoverable
Asset Example amount estimate
Intangible assets with indefinite Brand name with no foreseeable At any time during an annual
useful lives limit on its useful life period, provided it is done
at the same time each year
(IAS 36, para. 10)
Intangible assets not yet available Computer software being At any time during an annual
for use developed in-house period, provided it is done
(IAS 36, para. 10)
Goodwill acquired in a business At any time during an annual

combination period, provided it is done
(IAS 36, para. 96)
Source: Adapted from IFRS Foundation 2017, IAS 36 Impairment of Assets, paras 10, 96,
in 2017 IFRS Standards, IFRS Foundation, London, pp. A1146, A1163.
To reduce the burden of formally estimating the recoverable amounts of intangible assets with
indefinite useful lives, IAS 36 allows an entity to use the most recent calculation of these assets’
recoverable amounts (made in the previous period) in the current period, provided the following
conditions are met:
(a) if the intangible asset is tested for impairment as part of the cash-generating unit to which it
belongs [refer to ‘Part C: Impairment of cash-generating units’ in this module], the assets and
liabilities making up that unit have not changed significantly since the most recent recoverable
amount calculation;
(b) the most recent recoverable amount calculation resulted in an amount that exceeded the
asset’s carrying amount by a substantial margin; and
(c) based on an analysis of events that have occurred and circumstances that have changed
since the most recent recoverable amount calculation, the likelihood that a current
recoverable amount determination would be less than the asset’s carrying amount is
remote (IAS 36, para. 24).
To explore this topic further, read paras 10–11, 24 and 96 of IAS 36.
Refer to the Techworks Ltd financial statements, which are provided in the appendix to the
Study guide, and are also available on My Online Learning.
Read Note 1(j), which provides Techwork Ltd’s accounting policy in relation to impairment
of non‑financial assets including tangible and intangible assets.
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Impairment indicators
IAS 36 provides a list of external indicators (IAS 36, para. 12(a)–(d)), internal indicators (IAS 36,
para. 12(e)–(g)), and other impairment indicators (IAS 36, para. 12(h)) that, at a minimum, an entity
must consider when assessing whether an asset is impaired. An entity may also identify its own
indicators that an asset may be impaired (IAS 36, para. 13). Also note that most of the indicators
are more appropriate to assess an individual asset than a CGU of which they may be a part
(refer to ‘Part C: Impairment of cash-generating units’). Tables 7.4 and 7.5 summarise key
external and internal indicators as listed in IAS 36.
Table 7.4: Indicators of impairment based on external information sources
Indicator Explanation Example
Significant decline ‘[T]here are observable indications that A property experiences a significant
in asset’s value the asset’s value has declined during the decline in its market value due to
period significantly more than would be a deterioration in local economic
expected as a result of the passage of conditions.
time or normal use’ (IAS 36, para. 12(a)).
Significant ‘[S]ignificant changes with an adverse A competitor announces a new product

adverse changes effect on an entity have taken place whose price significantly undercuts
in environment or during the period, or will take place in the price at which the entity can sell its
market the near future, in the technological, product, or a regulatory change occurs
market, economic or legal environment which restricts the market for an entity’s
in which the entity operates or in the product. In either case, this change
market to which an asset is dedicated’ adversely affects the demand for the
(IAS 36, para. 12(b)). output produced by an asset or CGU.
Increases in ‘[M]arket interest rates or other market An entity owns shares in a subsidiary.
interest rates rates of return on investments have The market in which the subsidiary
or other market increased during the period, and operates has recently experienced an
rates of return those increases are likely to affect the increase in uncertainty due to economic
on investments discount rate used in calculating an factors. This uncertainty has resulted in
asset’s value in use and decrease the investors increasing the rate of return
asset’s recoverable amount materially’ they expect from investments similar to
(IAS 36, para. 12(c)). the subsidiary to compensate them for
the additional risks.
Note: An increase in market rates does

not automatically mean that an asset
or a CGU is impaired (IAS 36, para. 16).
For example, an increase in short-term
interest rates may not materially affect
the recoverable amount of an asset held
as a long-term investment. Alternatively,
previous analysis may have shown that
an asset’s recoverable amount is not
sensitive to an increase in market rates
because the cash flows from the asset
adjust to compensate for increases in
market rates.
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Market ‘[T]he carrying amount of the net assets An entity owns shares in an associate
capitalisation of the entity is more than its market that is listed on a stock exchange.
exceeded capitalisation’ (IAS 36, para. 12(d)). The market capitalisation of this
investment (estimated by multiplying
the number of shares owned by the
current share price) is much lower than
the carrying amount of the entity’s
share of the underlying net assets of
the associate.
Note: Care needs to be taken in

using this indicator, as the market
capitalisation of an entity may reflect a
range of factors that are not indicative
of the impairment of an asset. Further,
the entity may have evidence that the
asset is not sensitive to a decline in
its market capitalisation.
Source: Based on IFRS Foundation 2017, IAS 36 Impairment of Assets, paras 12, 16,
Table 7.5: Indicators of impairment based on internal information sources
Obsolescence or ‘[E]vidence is available of obsolescence An item of machinery becomes

physical damage or physical damage of an asset’ outdated due to technological change.
(IAS 36, para. 12(e)).
Change in asset ‘[S]ignificant changes with an adverse An entity has assets used to
use effect on the entity have taken place manufacture facsimile equipment.
during the period, or are expected to Due to the increased use of electronic
take place in the near future, in the communication (email, etc.), the entity
extent to which, or the manner in which, has decided to withdraw from the
an asset is used or is expected to be facsimile manufacturing market.
used. These changes include the asset
becoming idle, plans to discontinue or
restructure the operation to which an
asset belongs, plans to dispose of an
asset before the previously expected
date, and reassessing the useful life of
an asset as finite rather than indefinite’
(IAS 36, para. 12(f)).
Economic ‘[E]vidence is available from internal The net cash inflows from an asset
performance of reporting that indicates that the are lower than the net cash inflows
asset worse than economic performance of an asset forecast for that asset when it was
expected is, or will be, worse than expected’ originally purchased.
(IAS 36, para. 12(g)).
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Source: Based on IFRS Foundation 2017, IAS 36 Impairment of Assets, para. 12,
As noted in Module 5, in assessing whether there is any indication that a subsidiary, jointly
controlled entity or associate may be impaired after the payment of a dividend, an investor
should consider any available evidence that indicates:
• the carrying amount of the investment in the separate financial statements exceeds the
carrying amounts in the consolidated financial statements of the investee’s net assets,
including associated goodwill; or
• the dividend exceeds the total comprehensive income of the subsidiary, jointly controlled
entity or associate in the period the dividend is declared (IAS 36, para. 12(h)).
➤➤Question 7.1
Consider the situations below and comment on whether a formal estimate of the recoverable
amount of each entity’s assets is required. Explain your answer with reference to IAS 36.
(a) An asset of A Ltd has a history of profitable use within A Ltd’s operations and is currently
profitable. The most recent budgeted results of A Ltd show that the cash outflows related
to operating the asset are 20 per cent higher than originally budgeted.
(b) B Ltd manufactures computer chips for use in domestic appliances. One of B Ltd’s competitors
recently announced that it had developed a new generation of computer chips, which allows
the competitor to reduce its cost to manufacture chips by 15 per cent.
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(c) C Ltd operates in the gaming industry. Recent government regulations are expected to
increase competition in the sector, resulting in a loss of market share. In anticipation of
this increased competition, C Ltd plans to diversify its operations into hospitality and
entertainment activities. This diversification is expected to compensate the entity for the
loss of its market share in the gaming sector.
(d) The ordinary shares of D Ltd are listed on the stock exchange. The market capitalisation of
D Ltd at its most recent reporting date was $50 million. The carrying amount of D Ltd’s net
assets at that date was $47 million.
(e) E Ltd has significant operations in Country X. Country X has recently been affected by a natural
disaster. Although the operations of E Ltd were not directly affected by the natural disaster,
many of its suppliers were significantly affected and have ceased operations indefinitely.
As a consequence, the plant of E Ltd can operate at only half its normal capacity for the next
three years.
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Summary
Part A provided an overview of the IAS 36 requirements, including a discussion of the basic
principles relating to the impairment of assets. This part introduced the key requirements of
IAS 36, including the concepts of recoverable amount, fair value less costs of disposal and
value in use, and the scope of the standard. Most importantly, IAS 36 requires that an asset
be impaired when its carrying amount exceeds its recoverable amount. Impairment of assets
is important to users in evaluating the financial performance and position of an entity.
Part A also introduced the way in which assets that may be impaired under IAS 36 may be
evaluated through the use of external, internal and other indicators of impairment.
Part B will consider the procedures in IAS 36 to estimate the recoverable amount and account
for the impairment of assets on an individual asset basis.
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Part B: Impairment of individual assets

Introduction
Part B deals with the impairment of individual assets. The impairment of CGUs is discussed
in Part C.
When there is an indication that an asset may be impaired, IAS 36 requires an entity to make
a formal estimate of the asset’s recoverable amount so that this amount can be compared
to its carrying amount. An asset (or a CGU) is impaired when its recoverable amount is less
than its carrying amount (IAS 36, para. 8). As discussed in Part A, issues relating to the impairment
of assets are particularly important in changing economic circumstances. Example 7.1 reminds
us that impairment losses can significantly affect the financial results of entity.
The key issues considered in Part B include the measurement of recoverable amount, and how
to calculate and recognise an impairment loss or the reversal of a previous impairment loss.
Measurement of recoverable amount

As stated previously, ‘recoverable amount’ is the higher of an asset’s ‘fair value less costs of
disposal and its value in use’ (IAS 36, para. 6). This definition of recoverable amount reflects the
view that the economic benefits embodied in an asset can be recovered through either its sale
or use. Rational management will use an asset in a manner that generates the higher return.
To assess impairment, the carrying amount of an asset is then compared to its recoverable
amount. Diagrammatically, this is shown in Figure 7.2.
Figure 7.2: Carrying amount of an asset compared to its recoverable amount
Step 1: Determine Recoverable amount
equal to the higher of
Fair value less and

costs of disposal Value in use
Step 2: Compare Recoverable amount and Carrying amount

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If recoverable amount < carrying amount, an impairment loss has occured.

If recoverable amount > carrying amount, no further action is required.
Source: Picker, R., Leo, K., Loftus, J., Wise, V., Clark, K. & Alfredson, K. 2012,
Applying International Financial Reporting Standards, 3rd edn, Wiley, Brisbane, p. 569.
Example 7.2: Asset impairment

The board of directors of Brown Ltd (Brown) is concerned about the potential impairment of the
company’s three major assets under IAS 36. The directors have requested that Brown’s management
prepare a report for the board’s consideration that estimates the fair value less costs of disposal
and the value in use of these assets, and includes commentary about whether (and to what extent)
any impairment of the assets will be required. A summary of management’s findings are as follows:
Fair value less

costs of Recoverable Carrying
disposal Value in use amount amount
Asset $ $ $ $ Conclusion
1 200 000 240 000 240 000 210 000 No impairment

write-down
is required.
2 100 000 90 000 100 000 85 000 No impairment

write-down
is required.
3 300 000 280 000 300 000 340 000 An impairment

write-down
of $40 000
is required.
Although ‘recoverable amount’ is defined as the higher of fair value less costs of disposal and value
in use, this does not mean that it is always necessary to estimate both these measures, as in the
above example. It is only necessary to demonstrate that one of these measures exceeds an asset’s
carrying amount in order to conclude that an asset is not impaired (IAS 36, para. 19). For example,
if it is known that an asset’s fair value less costs of disposal exceeds the asset’s carrying amount, it is
not necessary to estimate the asset’s value in use, and vice versa. Estimating an asset’s fair value
less costs of disposal is often more straightforward than estimating its value in use. However, if no
reliable estimate of fair value less costs of disposal is available, the recoverable amount is measured
by reference to the value in use. These concepts will now be discussed.
Recoverable amount is estimated on an individual asset basis where an asset generates its own
cash inflows that are largely independent of the cash inflows generated by other assets or groups
of assets. For example, the cash inflows from an investment property measured at cost may be
determinable on an individual asset basis.
Commonly, an asset works with other assets to generate cash inflows—that is, as part of a CGU.
When this situation exists, IAS 36 requires the recoverable amount to be determined for the
CGU to which the asset belongs (see ‘Part C: Impairment of cash-generating units’). However,
the recoverable amount is determined on an individual asset basis if:
(a) the asset’s fair value less costs of disposal is higher than its carrying amount; or
(b) the asset’s value in use can be estimated to be close to its fair value less costs of disposal and
fair value less costs of disposal can be measured (IAS 36, para. 22).
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In these circumstances, the recoverable amount is estimated on an individual asset basis even
though the asset may form part of the carrying amount of a CGU.
For example, although it may form part of a CGU, an asset such a motor vehicle or item of
machinery may be able to be sold on a secondary market. In this case, the fair value less costs
of disposal of the asset in that market may be used to estimate the asset’s recoverable amount,
in accordance with the requirements in para. 22 of IAS 36.
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Recall from Part A that the recoverable amount of intangible assets that have an indefinite useful
life and intangible assets that are not yet available for use must be determined once a year
regardless of whether there is an indication of impairment. This determination must be made on
an individual asset basis unless, in accordance with the above discussion, the asset is tested as
part of the CGU to which it belongs. By contrast, goodwill is always tested as part of the CGU(s)
to which it has been allocated, in accordance with the procedures set out in IAS 36. This is
because goodwill works with other assets to generate cash inflows. The impairment of goodwill
is discussed in Part C.
➤➤Question 7.2
In developing IAS 36, the International Accounting Standards Committee (IASC)—the predecessor
to the current IASB—rejected a number of other proposals for the definition of ‘recoverable
amount’, including basing the definition on:
• the sum of undiscounted cash flows expected to be derived from an asset
• fair value
• value in use.
The basis for the IASC decision is set out in paras BCZ9–BCZ22 of IAS 36. What were the IASC’s
principal objections to these alternative definitions of ‘recoverable amount’?
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Fair value is defined as ‘the price that would be received to sell an asset or paid to transfer
a liability in an orderly transaction between market participants at the measurement date’
(IAS 36, para. 6). Further guidance on the determination of fair value is contained in IFRS 13
Fair Value Measurement (IFRS 13).
Costs of disposal are ‘incremental costs directly attributable to the disposal of an asset or
cash-generating unit, excluding finance costs and income tax expense’ (IAS 36, para. 6).
The requirement that these costs be ‘incremental’ means that they are only incurred if the
asset is disposed of (refer to IAS 36, para. 28). Examples of items included in and excluded
from costs of disposal are shown in Table 7.6.
Table 7.6: Items included in and excluded from costs of disposal
Examples of costs of disposal Items excluded from costs of disposal
• Legal costs • Interest expense incurred in financing the

• Stamp duty and similar transaction taxes purchase of an asset to be disposed of
• Costs to remove an asset from a particular • Income tax incurred on an asset’s disposal
location to effect a disposal • Employee termination benefits incurred due
• Costs to prepare an asset for its disposal to employee redundancies that occur after the
asset is disposed of
• Restructuring costs incurred after the asset is
disposed of
Source: Adapted from IFRS Foundation 2017, IAS 36 Impairment of Assets, paras 6, 28,
in 2017 IFRS Standards, IFRS Foundation, London, pp. A1144–5, A1150.
Where the disposal of an asset also requires the buyer to assume a liability, the fair value of the
asset and liability needs to be determined together (in effect, the net fair value needs to be
determined) and then adjusted by the costs of disposal (IAS 36, paras 6, 28).
Example 7.3: Fair value less costs of disposal of an asset

North Ltd (North) owns specialised dredging equipment used in deepening commercial waterways.
Because of the specialised nature of the equipment, an active market does not exist for these assets.
Based on recent similar transactions involving other companies (and after making appropriate
adjustments for differences between the types and conditions of the equipment sold), an expert
valuer has estimated that $1 million could be obtained from selling the equipment in an orderly sale.
Government levies of $5000 would be payable by North on the sale of the equipment. In addition,
North would be required to cover the estimated costs of $15 000 to dismantle and transport the
equipment to a potential buyer. North has not provided for these costs. The services of two specially
trained employees of North would be terminated if the equipment were to be sold. The termination
benefits payable to these employees would be in the order of $30 000. Legal fees of $12 000 would
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also be incurred in selling the equipment. The fee charged by the expert valuer for performing the
valuation was $7000.
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The fair value less costs of disposal of the equipment under IAS 36 is calculated as follows:
$
Gross proceeds 1 000 000
Less:
Government levies (5 000 )
Dismantling and transport costs (15 000 )
Legal fees (12 000 )
Valuation fee (7 000 )
Fair value less costs of disposal 961 000
Note: In accordance with para. 28 of IAS 36, the costs of disposal do not include the termination
benefits of $30 000 payable to the employees of North.
Value in use
Value in use is defined as ‘the present value of the future cash flows expected to be derived
from an asset or CGU’ (IAS 36, para. 6). Therefore, value in use is an entity-specific measurement
because the cash flows and discount rate will depend on the nature of the asset (or CGU).
Estimating the value in use of an asset (or a CGU) involves two steps.
Step 1: e
stimating the future cash inflows and outflows expected to be derived from the
continuing use of an asset (or a CGU) and from its ultimate disposal (IAS 36, para. 31(a)).
Step 2: determining an appropriate discount rate to apply to those cash flows so that they are
stated in present value terms (IAS 36, para. 31(b)).
The estimation of future expected cash flows and the determination of an appropriate discount
rate represent areas of significant professional judgment under IAS 36.
Step 1: Estimating expected future cash flows

Expected cash flows are vulnerable to changes in the economic environment, and changes in cash
flow estimates can give rise to the impairment of assets. This is illustrated in the extract below:
Cash inflows (sales) may decline when growth stagnates, or even falls. And they will be less certain
as there is more risk. This will mean greater effort is needed to update cash flows properly and
not just to roll forward those from last year. Projections that are backward-looking, e.g. those that
base sales on last year or the last several years, will no longer be appropriate in declining markets.
It is natural to assume a worst case scenario of no growth, but for many companies, that will not
be realistic and sales will actually be lower. Cash outflows will also be affected by increased input
costs and must be updated appropriately (Ernst & Young 2008, p. 4).
A simple illustration of the calculation of the value in use of an asset is provided in Example 7.4.
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Example 7.4: Calculating the value in use of an asset

South Ltd (South) has developed leading-edge software that detects and removes unsolicited emails
(spam) that are often received by computer systems. The expected useful life of the asset is five years.
South’s management has estimated the future net cash flows from the expected sale of its software
product over the next five years.
A discount rate of 15 per cent is considered appropriate for the cash flows associated with this product.
The present value factor is calculated using the following formula: 1 / (1 + k)n, where k = discount rate
and n = number of periods to settlement. For 20X6, this will be 1 / 1.151 = 0.86957.
The value in use of the product has been estimated in accordance with IAS 36 by multiplying the future
cash flows by the present value factor as follows:
Discounted
Future cash flows Present value factor at future cash flows
Year $ 15% discount rate $
20X6 230 000 0.86957 200 001
20X7 253 000 0.75614 191 303
20X8 273 000 0.65752 179 503
20X9 290 000 0.57175 165 808
20Y0 304 000 0.49718 151 143
Value in use 887 758
Factors to consider in value in use calculations

The following five elements, or factors, in Table 7.7 are considered when calculating the value
in use of an asset (IAS 36, para. 30).
Table 7.7: Elements included in value in use
Element Where taken into account
Estimated future cash flows expected to be derived from an Future cash flows
asset (IAS 36, para. 30 (a))
Expectations about possible variations in the amount or timing Future cash flows or discount rate
of those future cash flows (IAS 36, para. 30(b))
The time value of money (IAS 36, para. 30(c)) Discount rate
The price for bearing the uncertainty inherent in the asset Future cash flows or discount rate
(IAS 36, para. 30(d))
Other factors, such as illiquidity, that market participants Future cash flows or discount rate
would reflect in pricing the future cash flows the entity expects
to derive from the asset (IAS 36, para. 30(e))
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Source: Based on IFRS Foundation 2017, IAS 36 Impairment of Assets, para. 30,
Each of these factors may be influenced by changes in the economic environment. Factors (b),
(d) and (e) of para. 30 of IAS 36 can be reflected as either adjustments to the discount rate
(traditional approach) or as adjustments to the future cash flows (expected cash flow approach—
refer to IAS 36, Appendix A). Each approach will now be discussed.
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Traditional approach
The traditional approach involves adjustments for the factors in Table 7.7 by incorporating those
factors into the discount rate. A disadvantage of the traditional approach is that it depends on
identifying an interest rate that is proportionate to the risk. This, in turn, depends on finding an
asset with similar characteristics to the one being measured and being able to observe the interest
rate on that other asset. Therefore, the traditional approach is difficult to apply where no market
for the asset exists or in circumstances where there are no assets with similar characteristics.
Expected cash flow approach

Adjusting the future cash flows for the factors in Table 7.7 is referred to as the expected cash flow
approach. This approach is based on forming expectations about possible cash flows rather than
about the single most likely cash flow. To arrive at the overall expected present value of cash
flows, possible cash flows are assigned probabilities. Calculations under the expected cash flow
approach are generally regarded as providing better estimates than the traditional approach.
However, a disadvantage is that such calculations can be more complex. Paragraph A12 of IAS 36
notes that the ‘expected cash flow approach is subject to a cost-benefit constraint’.
Appendix A to IAS 36 is an integral part of the standard. It provides guidance on the use of present
value techniques in measuring value in use. To explore this topic further, read paras 30–32 and
A1–A14 (in Appendix A) of IAS 36. Pay particular attention to para. A3, which outlines the general
principles for present value measurement.
Estimating future cash flows

IAS 36 contains guidance on estimating future cash flows. A summary is provided in Table 7.8.
Table 7.8: Principles for estimating future cash flows
Requirement Principles
Base cash flow projections • Based ‘on reasonable and supportable assumptions that
represent management’s best estimate of the range of economic
conditions that will exist over the remaining useful life of the asset’
(IAS 36, para. 33(a))
• ‘Greater weight … given to external evidence’ than management
expectations (IAS 36, para. 33(a))
• Based on the ‘most recent financial budgets/forecasts approved
by management’ (IAS 36, para. 33(b))
• Must exclude cash flows ‘expected to arise from future
restructurings or from improving or enhancing the asset’s
performance’ (IAS 36, para. 33(b))
• Must ‘cover a maximum period of five years, unless a longer period
can be justified’ (IAS 36, para. 33(b))
• Cash flow projections must take into account management’s
accuracy in estimating past cash flows
Cash flows beyond the • Estimated by ‘extrapolating the projections based on the budgets/
budget/forecast period forecasts using a steady or declining growth rate for subsequent
years, unless an increasing rate can be justified’
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• Growth rate to ‘not exceed the long-term average growth rate for
the products, industries or country … in which the entity operates
… unless a higher rate can be justified’ (IAS 36, para. 33(c))
Source: Based on IFRS Foundation 2017, IAS 36 Impairment of Assets, paras 33, 36,

Example 7.5: Calculation of value in use

West Ltd (West) operates a manufacturing plant, which has a useful life of 12 years. West has estimated
the plant’s future net cash flows beyond a period of five years from its most recent forecasts by
extrapolating the projections based on a declining growth rate for subsequent years.
In 20Y1, West estimates that the growth rate for its product will be 3 per cent, which is lower
than the long-term growth rate for the industry in which it operates. Revenues will then decline,
which means there will be negative growth rates. Revenue for 20Y1–20Y6 is calculated using the
following formula: Previous year cash flows × (1 + k), where k = the growth rate. In 20Y1, this will be
$304 000 × 1.03 = $313 120. In 20Y2, this will be $313 120 × 0.98 = $306 858.
A discount rate of 15 per cent is considered appropriate for the cash flows associated with this product.
The value in use of the product has been estimated in accordance with IAS 36 as follows.
Future Discounted
Long-term cash flows Present value factor at future cash flows
Year growth rates $ 15% discount rate $
20X6 230 000 0.86957 200 000
20X7 253 000 0.75614 191 303
20X8 273 000 0.65752 179 503
20X9 290 000 0.57175 165 808
20Y0 304 000 0.49718 151 143
20Y1 3% 313 120 0.43233 135 371
20Y2 –2% 306 858 0.37594 115 360
20Y3 –6% 288 446 0.32690 94 293
20Y4 –15% 245 179 0.28426 69 695
20Y5 –25% 183 884 0.24719 45 454
20Y6 –67% 60 682 0.21494 13 043
Value in use 1 360 973
Source: Adapted from IFRS Foundation 2017, IAS 36 Impairment of Assets,

Composition of estimates of future cash flows

The estimated future cash flows include certain cash flows, while excluding others. These are
summarised in Table 7.9.
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Table 7.9: Composition of future cash flows
Cash flows included Cash flows excluded
• ‘Cash inflows from the continuing use of asset’ • ‘Cash inflows from assets that generate cash
(IAS 36, para. 39(a)) inflows that are largely independent of the
• ‘Cash outflows … necessarily incurred to cash inflows from the asset under review’
generate the cash inflows from continuing use’ (e.g. financial assets such as receivables that
(IAS 36, para. 39(b)) generate their own cash inflows) (IAS 36,
• Note: Includes cash flows directly attributed para. 43(a))
to the asset or allocable ‘on a reasonable and • Cash outflows relating to obligations for which
consistent basis to the asset’, including an a liability has been recognised (e.g. payables,
appropriate proportion of future overheads pensions or provisions) (IAS 36, para. 43(b))
(IAS 36, para. 39(b)) • Cash outflows relating to ‘a future restructuring
• Net cash flows from disposing asset ‘at end to which an entity is not yet committed’
of its useful life’ (IAS 36, para. 39(c)) (IAS 36, para. 44(a))
• Future capital expenditures that will
‘improve or enhance’ the performance
of the asset beyond its current condition
(IAS 36, para. 44(b))
• ‘Cash inflows or outflows from financing
activities’ (IAS 36, paras 50(a) and 51)
• ‘Income tax receipts or payments’ relating
to the asset (IAS 36, paras 50(b) and 51)
Source: Based on IFRS Foundation 2017, IAS 36 Impairment of Assets, paras 39, 43, 44, 50, 51,
Inflation
Cash flows used in calculating value in use may be estimated in real terms (excluding the effect of
inflation) or nominal terms (including the effect of inflation). Example 7.6 illustrates this difference.
Example 7.6: Nominal and real rent

If future cash flows are estimated in nominal terms, this means that the estimated future cash flows
are the amounts that an entity expects to pay or receive. For example, if rental income is currently
$100 per annum, inflation is expected to be 5 per cent and rent is expected to increase with inflation,
the nominal estimated cash flow for next year is $105, while in real terms the cash flow would be $100.
The discount rate applied to the cash flows should be consistent with the estimates of cash flows.
Therefore, if cash flows are estimated in real terms, the discount rate is adjusted to exclude the
effect of general inflation. By contrast, if cash flows are estimated in nominal terms, then the
discount rate includes the effect of general inflation. IAS 36 does not express a preference for
which method should be used.
In addition to general inflation, specific price inflation reflects price increases or decreases that
are particular to an asset. Specific price inflation would be reflected in the cash flows whether
expressed in real or nominal terms.
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Figure 7.3 summarises these concepts.

Figure 7.3: Estimating cash flows in real or nominal terms
Effect of price increase included in discount rate Future cash flows

attributable to inflation are ... estimated in nominal terms
excluded from
discount rate
Future cash flows estimated

in real terms (but include
future specific price changes)
To explore this topic further, read paras 39–41, 43–44 and 50–51 of IAS 36.
Current asset condition

Future cash flows are ‘estimated for the asset in its current condition’ (IAS 36, para. 44).
Therefore, future cash outflows necessary to maintain the asset in its current condition are
included in the value in use calculation. This would include routine capital expenditures that were
envisaged when the asset was committed to its current use. For example, if an item of machinery
is expected to provide 100 000 hours of service, then the cash outflows for routine maintenance
that was expected to achieve that level of service is included in the future cash outflows.
Excluded from value in use calculations are estimated future cash inflows or outflows arising from
one of the following:
• a future restructuring to which an entity is not yet committed
• future capital expenditures that will improve or enhance the performance of the asset beyond
its current condition (IAS 36, para. 44).
For example, a major upgrade of an item of machinery to enhance that machinery’s level of
service beyond its current level (e.g. 100 000 hours in the above example) to which the entity is
not yet committed would not be included in the future cash flows.
When an entity is committed to a restructuring according to IAS 37 Provisions, Contingent

Liabilities and Contingent Assets, any increase in cash inflows expected to result from such
a restructuring, as well as the cash outflows of the restructuring itself, are included in value in
use calculations.
To explore this topic further, read paras 44–49 and paras IE1–22 (Example 6) in IAS 36. Example 6
demonstrates how future improvements and enhancements affect value in use calculations.
Please note that the example ignores tax effects.
Disposal value
The net cash flows that an entity expects to receive (or be paid) from the disposal of an asset at
the end of its useful life reflects ‘the amount that an entity expects to obtain from the disposal of
the asset in an arm’s length transaction between knowledgeable, willing parties, after deducting
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the estimated costs of disposal’ (IAS 36, para. 52). In effect, this reflects the net fair value of the
asset at the time of disposal.
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In estimating disposal value, an entity uses current prices and costs for similar assets that
have reached the end of their useful lives as at the date of the value in use estimate and been
used in a similar manner to that in which the asset is expected to be used (IAS 36, para. 53).
Further, if an entity has expressed its value in use calculation in nominal terms, it will be necessary
for the current prices and costs of similar assets to be adjusted for ‘future price increases
due to general inflation and specific future price increases or decreases’ (IAS 36, para. 53(b)).
This means that general and specific price inflation is included the disposal value estimate.
In contrast, if the entity expresses its value in use calculation in real terms, the disposal value
would exclude general inflation but include specific price inflation.
To explore this topic further, read paras 52–53A of IAS 36.
Foreign currency cash flows

An asset may generate future cash flows in a foreign currency. In this situation, IAS 36 requires
the future cash flows to be estimated ‘in the currency in which they will be generated and then
discounted at a rate appropriate for that currency’ (IAS 36, para. 54). The resulting present
value is then translated ‘using the spot exchange rate at the date of the value in use calculation’
(IAS 36, para. 54).
To explore this topic further, read para. 54 of IAS 36.
Step 2: Determining an appropriate discount rate

Once the cash flows that an entity expects to derive from an asset have been estimated,
the present value of those cash flows must be determined by applying an appropriate
discount rate to those cash flows.
The discount rate must be a pre-tax rate (IAS 36, para. 55) and reflect the ‘current market
assessments of (a) the time value of money; and (b) the risks specific to the asset for which the
future cash flow estimates have not been adjusted’ (IAS 36, para. 55). This means that the entity
must consider the market’s view of these matters rather than impose its own view.
An asset-specific rate that reflects the market’s view may come from various sources,
including market rates of return used for similar assets in current market transactions or the
weighted average cost of capital (WACC) of a listed entity with a single asset (or portfolio of
assets) similar to the asset under review. In practice, current market rates of return may only
be observable for a limited range of assets, such as property. Where an asset-specific rate is
not available, IAS 36 specifies that the following ‘surrogate’ (substitute) rates can be used:
(a) the entity’s [WACC] determined using techniques such as the Capital Asset Pricing Model
[CAPM];
(b) the entity’s incremental borrowing rate; and
(c) other market borrowing rates (IAS 36, para. A17).
(Note: Candidates are not expected to have a detailed understanding of CAPM for the purposes
of this module.)
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These ‘surrogate’ rates must be adjusted to:

• ‘reflect the way that the market would assess the specific risks associated with’ the projected
cash flows (including ‘country risk, currency risk and price risk’)
• ‘exclude risks that are not relevant to the asset’s estimated cash flows or for which the
estimated cash flows have already been adjusted’, such as the entity’s credit risk, which are
not relevant to the market’s assessment of the risks specific to the asset (IAS 36, para. A18).
The discount rate must be independent of the entity’s capital structure and the way that it
has financed the purchase of the asset. This is consistent with the IAS 36 requirement that
estimated ‘future cash flows shall not include cash inflows or outflows from financing activities’
(IAS 36, para. 50).
To explore this topic further, read paras 55–57 and A15–A21 (in Appendix A) of IAS 36.
➤➤Question 7.3
East Ltd (East) owns a machine used in the manufacture of steering wheels, which are sold directly
to major car manufacturers.
• The machine was purchased on 1 January 20X3 at a cost of $500 000 through a vendor
financing arrangement on which interest is being charged at the rate of 10 per cent per annum.
• During the year ended 31 December 20X4, East sold 10 000 steering wheels at a selling
price of $190 per wheel.
• The most recent financial budget approved by East’s management, covering the period
1 January 20X5–31 December 20X9, indicates that the company expects to sell each steering
wheel for $200 during 20X5, the price rising in later years in line with a forecast inflation of
3 per cent per annum.
• During the year ended 31 December 20X5, East expects to sell 10 000 steering wheels.
This number is forecast to increase by 5 per cent each year until 31 December 20X9.
• East estimates that each steering wheel costs $160 to manufacture, which includes $110
variable costs, $30 share of fixed overheads and $20 transport costs.
• Costs are expected to rise by 1 per cent during 20X6, and then by 2 per cent per annum
until 31 December 20X9.
• During 20X7, the machine will be subject to regular maintenance costing $50 000.
• In 20X5, East expects to invest in new technology costing $100 000. This technology will
reduce the variable costs of manufacturing each steering wheel from $110 to $100 and the
share of fixed overheads from $30 to $15 (subject to the availability of technology, which is
still under development).
• East is depreciating the machine using the straight-line method over the machine’s 10-year
estimated useful life. The current estimate (based on similar assets that have reached the
end of their useful lives) of the disposal proceeds from selling the machine is $80 000 net
of disposal costs. East expects to dispose of the machine at the end of December 20X9.
• East has determined a pre-tax discount rate of 8 per cent, which reflects the market’s
assessment of the time value of money and the risks associated with this asset.
Assume a tax rate of 30 per cent. What is the value in use of the machine in accordance with IAS 36?
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Recognising and measuring an impairment loss

An impairment loss is recognised to the extent that an asset’s carrying amount exceeds its
recoverable amount (IAS 36, para. 59). This loss is immediately recognised in the statement of
profit or loss (P&L), unless the asset is carried at a revalued amount (IAS 36, paras 60 and 61).
If the asset is carried at a revalued amount under another standard, any impairment loss of the
revalued asset is treated as a revaluation decrease under that other standard (IAS 36, para. 60).
This means that any impairment loss is dealt with in two steps. First, the loss is recognised in
other comprehensive income (OCI) as a reduction in the asset revaluation surplus to the extent
that the loss is covered by the surplus. Then, any amount not covered by the reserve is charged
to P&L (IAS 36, para. 61).
The revaluation decrease on assets (such as property, plant and equipment) measured at fair
value may be close to the impairment loss required under IAS 36, provided that the costs
of disposal are negligible. This is explained in para. 5 of IAS 36. Note that accounting for
revaluations of property, plant and equipment under IAS 16 Property, Plant and Equipment
are made on an individual asset basis rather than by asset class.
IAS 36 does not specifically comment on how the carrying amount of an asset should be
adjusted for impairment losses—in effect, it does not state what the ‘credit entry’ should be.
In Example 7.7, the accumulated impairment loss account, which has similar properties to an
accumulated depreciation account, has been credited. This is consistent with the requirement in
para. 73(d) of IAS 16, which states that entities must disclose, for each class of property, plant and
equipment, ‘the gross carrying amount and the accumulated depreciation (aggregated with
accumulated impairment losses) at the beginning and end of the period’. A similar provision
exists for intangible assets in para. 118(c) of IAS 38. These two standards imply that there is no
requirement to set the balance of accumulated depreciation or amortisation against the gross
amount of the asset or to create a specific impairment account. Rather, an account such as
‘accumulated depreciation and impairment losses’ may be sufficient.
The credit entry (i.e. accumulated impairment loss) may alternatively be made directly against
the asset account.
Example 7.7: Recognising an impairment loss

On 31 December 20X1, an entity acquired an asset for $100 000. This cost is depreciated over 20 years
using the straight-line method ($5000 depreciation charged each year).
The recoverable amount of the asset at 31 December 20X3 is estimated to be $80 000. As at 31 December
20X3, an impairment loss of $10 000 needs to be recognised, based on the difference between the
carrying amount of the asset of $90 000 ($100 000 less two years’ depreciation at $5000 per annum)
and its recoverable amount of $80 000. Depreciation is then charged at $4444 (i.e. $80 000 / 18 years)
on a continuing basis.
Dr Impairment loss (expense) $10 000

Cr Accumulated impairment loss (or asset)† $10 000
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†
Alternatively, the credit entry could have been processed against the asset account.
Once an impairment loss on an asset is recognised, any subsequent depreciation or amortisation is

based on the revised recoverable amount (IAS 36, para. 63).

Reversals of impairment losses

IAS 36 requires entities to review whether a previously recognised loss may have reversed,
either wholly or partially (IAS 36, para. 110). If any indication of reversal exists, the entity is
required to formally estimate an asset’s recoverable amount.
The factors to consider when assessing whether impairment losses have reversed are the opposite
kind of factors to those that provided indications of the original impairment. For example,
an indication that an impairment loss has reversed occurs when:
• ‘there are observable indications that the asset’s value has increased significantly during
the period’ (IAS 36, para. 111(a)), or
• ‘evidence is available from internal reporting that indicates that the economic performance
of the asset is, or will be, better than expected’ (IAS 36, para. 111(e)).
There are constraints on the amount of a reversal of an impairment loss that can be recognised.
A reversal is limited to the lower of the:
• recoverable amount
• carrying amount of the asset, net of amortisation or depreciation, had no impairment been
recognised (IAS 36, para. 117).
A further constraint on impairment reversal is that a previously recognised impairment loss on

goodwill can never be reversed.
A reversal of an impairment loss for an asset measured at cost is recognised in P&L. In contrast,
the reversal of an impairment loss for an asset measured at a revalued amount (such as property,
plant and equipment measured at fair value) is recognised as a revaluation increase.
Example 7.8 illustrates the application of these impairment loss reversal requirements.
Example 7.8: Reversal of an impairment loss

Assume the case facts of Example 7.7, and then consider the following new facts.
At 31 December 20X4, a favourable reassessment of the recoverable amount occurs to the extent that
the recoverable amount of the asset is now estimated to be $88 000. This needs to be compared to the
carrying amount (net of depreciation) of the asset at 31 December 20X4 if the original impairment were
not recognised. In this case, this would be the original cost of $100 000 less three years of depreciation
at $5000 per annum, or $85 000.
Under IAS 36, the asset is written up to the lower of:

• its revised recoverable amount (i.e. $88 000), or
• the carrying amount (net of depreciation) of the asset if the original impairment loss were not
recognised (i.e. $85 000).
Therefore, the asset is written up to $85 000 from its carrying amount before the reversal of $75 556
(i.e. $80 000 less $4444 accumulated depreciation).
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Asset—current carrying amount:

$
Asset—original cost 100 000
Less: Accumulated impairment loss 10 000
The revised carrying amount is estimated to be $88 000. The asset cannot be revalued beyond what
the carrying amount would have been if the asset had not previously been impaired.
Carrying amount assuming no previous impairment recognised:
$ $
Asset—original cost 100 000
The asset can only be revalued to $85 000.
Dr Asset (or Accumulated impairment loss) 9 444

Cr Impairment loss—reversal (profit or loss) 9 444
Summary
Part B considered the impairment of individual assets. It also outlined the requirements of IAS 36
in relation to the calculation of recoverable amount. The recoverable amount is the higher of either
fair value less costs of disposal or value in use. Value in use estimates are dependent on estimating
future cash flows and appropriate discount rates to take into account the time value of money.
Finally, impairment losses need to be reviewed and adjusted annually.
Part C will consider the procedures in IAS 36 to estimate the recoverable amount and account
for the impairment of CGUs and goodwill.
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Part C: Impairment of cash-generating

units
Introduction
A CGU is ‘the smallest identifiable group of assets that generates cash inflows that are largely
independent of the cash inflows from other assets or groups of assets’ (IAS 36, para. 6). CGUs are
only relevant for impairment testing when the recoverable amount of an asset is unable to be
individually determined (IAS 36, para. 66). Goodwill is an example of an asset for which the
recoverable amount is unable to be individually determined.
Part C addresses how to identify CGUs and determine their carrying amount, including how to
identify corporate assets that form part of a CGU. The identification of CGUs is a matter requiring
significant professional judgment. Part C also considers the requirements of IAS 36 relating to the
allocation of goodwill to CGUs and the impairment testing of assets, including goodwill, as part
of the CGU to which they belong.
The IAS 36 principles for identifying potential impairment of individual assets that were considered
in Part B apply equally to CGUs (IAS 36, para. 7). Therefore, where there is an indication that a CGU
may be impaired, a formal estimate of the recoverable amount of the CGU must be undertaken
(IAS 36, para. 8). The recoverable amount of a CGU is the higher of the CGU’s ‘fair value less costs
of disposal and its value in use’ (IAS 36, para. 18). Recoverable amount is then compared to the
CGU’s carrying amount. An impairment is recognised if the carrying amount of the CGU exceeds
its recoverable amount.
Recoverable amount: Individual asset or

cash‑generating unit?
A determination must be made on whether the recoverable amount of an asset, for which there is
an indication of impairment, is made on an individual asset basis or as part of the CGU to which
the asset belongs. IAS 36 requires the recoverable amount to be determined on an individual
asset basis (IAS 36, para. 66), unless this is not possible because:
(a) the asset’s value in use cannot be estimated to be close to its fair value less costs of disposal; and
(b) the asset does not generate cash inflows that are largely independent of those from other
assets (IAS 36, para. 67).
Where conditions (a) and (b) apply, the recoverable amount of the asset is estimated as part of
the CGU to which it belongs. This decision scenario is also summarised in Figure 7.4.
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Figure 7.4: Decision scenario for estimating recoverable amount on individual

asset or cash-generating unit basis
Can the asset’s value in use be Yes
Calculate recoverable amount

estimated to be close to its fair value
for the individual asset

less costs to sell? (IAS 36, para. 67)
No
Does the asset generate cash Yes

inflows largely independent of
other assets? (IAS 36, para. 67)
No
Calculate recoverable amount for CGU
IAS 36 illustrates this point by reference to a mining entity that owns a private railway to support
its mining activities. The railway, by itself, does not generate its own cash inflows. Rather, it is the
combination of the railway and other assets associated with the mine that generates independent
cash inflows. Therefore, condition para. 67(b) of IAS 36 is satisfied. Further, although the railway
could be sold for its scrap value, that amount is likely to be different to its value in use as part of
the mine of which it is a part (i.e. IAS 36, para. 67(a)). This is because the collective benefits of using
the railway together with the other mining assets could result in the value in use of the railway not
being close to its fair value less costs of disposal. Therefore, as conditions (a) and (b) are satisfied,
the recoverable amount of the railway is tested as part of the CGU to which it belongs, that is,
the mine as a whole (IAS 36, para. 67).
Identifying cash-generating units

As provided earlier, IAS 36 defines a CGU as ‘the smallest identifiable group of assets that
generates cash inflows that are largely independent of the cash inflows from other assets or
groups of assets’ (IAS 36, para. 6). This definition requires entities to consider the lowest level
of aggregation of assets that work together to generate their own cash inflows.
IAS 36 cautions that although cash inflows may be associated with a particular asset, they may
not be able to be earned independently of other assets. To illustrate this point, IAS 36 cites the
example of a bus company that provides services on five routes under contract to a municipality.
One of these routes operates at a significant loss. However, as the bus company does not have
the option to withdraw its services from any of the routes (including the unprofitable route)
because of the contract in place, the CGU for each route is the bus company as a whole
(IAS 36, para. 68).
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The identification of CGUs involves professional judgment. As a guide, the following key factors
should be considered:
• At what level does management monitor the entity’s operations? For example, is it by
product lines, businesses or geographical areas?
• At what level does ‘management make decisions about continuing or disposing of the
entity’s assets and operations’ (IAS 36, para. 69)?
IAS 36 also includes a specific requirement for assets that have an active market for the output
they produce (refer to IAS 36, para. 70). An active market is defined in IFRS 13 as:
… a market in which transactions for the asset or liability take place with sufficient frequency and
volume to provide pricing information on an ongoing basis (IFRS 13, Appendix A).
If there is an active market for the output produced by an asset or group of assets, the assets
concerned are always identified as a CGU, ‘even if some or all of the output is used internally’
(IAS 36, para. 70). For example, an entity may have established a business unit that is involved in
the smelting of aluminium (an ‘upstream unit’). It may also have another business that processes
the aluminium into value-added products (a ‘downstream unit’). If an active market exists for the
product of the upstream unit, that unit must be identified as a CGU, even though some or all
of the output of the upstream unit may be used by the downstream unit.
Value in use calculations arising from internal transfers of product must be based on an arm’s
length transfer price when estimating cash flows for the relevant CGUs (IAS 36, para. 70).
This requirement has particular application to vertically integrated operations, such as the
‘upstream’ and ‘downstream’ units in the example.
Once CGUs are identified, they are consistently applied across reporting periods, unless a
change is warranted, such as a company restructure (IAS 36, para. 72).
To explore this topic further, read paras 6 and 66–73 of IAS 36.
Question 7.4 requires the appropriate CGU to be identified using situations based on the
‘Illustrative examples’ section of IAS 36 (paras IE1–89).
➤➤Question 7.4
Example 1: Identification of CGUs, IAS 36, Illustrative examples, para. IE1.
(a) Retail store chain
Store X belongs to a retail store chain, M. X makes all its retail purchases through M’s
purchasing centre. Pricing, marketing, advertising and human resources policies (except for
hiring X’s cashiers and sales staff) are decided by M. M also owns five other stores in the
same city as X (although in different neighbourhoods) and 20 stores in other cities. All stores
are managed in the same way as X. X and four other stores were purchased five years ago,
and goodwill was recognised.
Is X a CGU?
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(b) Plant for an intermediate step in a production process

A significant raw material used for plant Y’s final production is an intermediate product
bought from plant X of the same entity. X’s products are sold to Y at a transfer price that
passes all margins to X. Sixty per cent of X’s final production is sold to Y, and the remaining
40 per cent is sold to customers outside the entity. Eighty per cent of Y’s final production is
sold to customers outside the entity.
For each of the following cases, what are the CGUs for X and Y?
Case 1: X could sell the products it sells to Y in an active market. Internal transfer prices are
higher than market prices.
Case 2: There is no active market for the products X sells to Y.
Recoverable amount and carrying amount

of a cash-generating unit (impairment of
cash‑generating units)
As defined in the introduction to Part C, the recoverable amount of a CGU is the higher of its
‘fair value less costs of disposal and its value in use’ (IAS 36, para. 18). Determining the carrying
amount of a CGU and allocating the amount of any impairment loss to individual assets within
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that CGU are often more complicated than for individual assets.
The carrying amount of a CGU must be determined consistently ‘with the way in which its
recoverable amount is determined’ (IAS 36, para. 75). To this end, the carrying amount of a
CGU is determined as illustrated in Figure 7.5 (IAS 36, para. 76).
Figure 7.5: Carrying amount of a cash-generating unit
Assets allocated
Assets directly Purchased
CGU carrying on reasonable
= attributed to + + goodwill expected
amount and consistent
CGU to benefit CGU
basis to CGU
Note: Do not
include liabilities
For example, corporate
assets allocable
on such basis
Two exceptions to this
rule apply (refer below)
Per Figure 7.5, the two situations where the carrying amount of a CGU would include recognised
liabilities are:
1. when the sale of a CGU would require a buyer to assume a liability (or liabilities)—in this
case, the recognised liability would be deducted from the CGU’s value in use and its
carrying amount (IAS 36, para. 78)
2. when it is only practical to determine the recoverable amount of a CGU by including assets
(e.g. receivables and other financial assets) or liabilities (e.g. payables, pensions or other
provisions) (IAS 36, para. 79). This may tend to occur for CGUs that are large in size relative
to the entity. In this case, the carrying amount of the CGU is increased for those assets and
decreased for those liabilities.
IAS 36 highlights the importance of including in the CGU all assets that contribute to the cash
inflows or cash outflows of the CGU. Otherwise, a CGU may not appear to be impaired when,
in fact, it is impaired due to its carrying amount being understated (IAS 36, para. 77).
Some assets that contribute to the cash flows of a CGU may not be capable of being allocated
to that CGU on a reasonable and consistent basis. This includes corporate assets and goodwill
(IAS 36, para. 77). The next section covers the requirements in IAS 36 for testing these assets
for impairment.
Testing cash-generating units with goodwill for impairment

In the acquisition of a business that gives rise to purchased goodwill, that goodwill needs to be
allocated to the CGU, or group of CGUs, expected to benefit from the goodwill (this is discussed
in further detail in this section). The CGU, or group of CGUs, to which goodwill is allocated may
be different to the CGU, or group of CGUs, to which other assets that make up the acquired
business are allocated.
When goodwill relates to a CGU but has not been allocated to that CGU, the CGU is tested
for impairment whenever there is an indication that the CGU may be impaired (IAS 36, para. 88).
This is the same screening procedure required for testing individual assets for impairment
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(IAS 36, para. 9). Where there is an indication that impairment may exist, the carrying amount
of the CGU (excluding any goodwill) is compared to its recoverable amount, and any impairment
loss recognised.
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The impairment testing procedures for CGUs to which goodwill has been allocated are stricter.
IAS 36 requires a formal estimate of the recoverable amount of a CGU (or group of CGUs)
to which goodwill has been allocated at least once per year, regardless of whether there is
any indication that the CGU (or group of CGUs) may be impaired (IAS 36, para. 10(b)).
Similarly, the recoverable amount of a CGU that includes any intangible asset that has an indefinite
useful life or is not yet available for use must be formally estimated at least once per year,
regardless of whether there is any indication that the CGU may be impaired (IAS 36, para. 10(a)).
IAS 36 also requires that the recoverable amount of a CGU (or group of CGUs) to which goodwill
has been allocated must be formally estimated whenever there is an indication that the CGU
(or group of CGUs) may be impaired (para. 90).
To explore this topic further, read paras 9–10 and 88–90 of IAS 36.
Timing of impairment tests

In accordance with para. 96 of IAS 36, the requirements in Table 7.10 apply to the annual testing
of goodwill for impairment.
Table 7.10: Timing of impairment tests
Scenario Timing of annual impairment test
CGU (or group of CGUs) to which goodwill has Any time during an annual period, but must be
been allocated at the same time each year
Different CGUs may be tested for impairment at

different times throughout the year
Some or all of the goodwill allocated to a CGU (or Before the end of the current annual period
group of CGUs) arose from a business combination
that occurred during the current annual period
If there is an indication of impairment of an asset (excluding goodwill) that is within a CGU that
includes goodwill, the asset is tested for impairment first, and any impairment loss is recognised
on that individual asset before the entire CGU is tested for impairment. This ensures that
the carrying amount of individual assets included in a CGU is appropriate before being included
in the impairment test for the entire CGU. Similarly, if there is an indication of impairment of
a CGU that forms part of a group of CGUs to which goodwill has been allocated, impairment
testing procedures are applied to the individual CGU before being applied to the group of
CGUs (IAS 36, para. 97).
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The concept of materiality applies in testing the recoverable amount of a CGU (or group of
CGUs) to which goodwill has been allocated. Therefore, the most recent detailed calculation
made in a preceding period of the recoverable amount of a CGU to which goodwill has been
allocated may be used in the impairment test of that CGU in the current period (IAS 36, para. 99),
provided that the following conditions are satisfied:
(a) the assets and liabilities making up the unit have not changed significantly since the most
recent recoverable amount calculation;
(b) the most recent recoverable amount calculation resulted in an amount that exceeded the
carrying amount of the unit by a substantial margin; and
(c) based on an analysis of events that have occurred and circumstances that have changed since
the most recent recoverable amount calculation, the likelihood that a current recoverable
amount determination would be less than the current carrying amount of the unit is remote
(IAS 36, para. 99).
Allocating goodwill to cash-generating units

As goodwill works with other assets to generate economic benefits, its carrying anount must
be allocated to each CGU that is expected to benefit from the goodwill. The requirements in
Table 7.11 apply when allocating goodwill to a CGU.
Table 7.11: Requirements for allocating goodwill to cash-generating units
Requirement Comments
Goodwill is allocated to a CGU (or group of This applies regardless of whether the acquiree’s
CGUs) expected to benefit from an acquisition other assets or liabilities that gave rise to the
(IAS 36, para. 80). goodwill are assigned to the same CGU (or group
of CGUs) to which the goodwill has been allocated.
Changes to the goodwill allocation are only possible

where an entity later reorganises its reporting
structure ‘in a way that changes the composition
of one or more’ CGUs (IAS 36, para. 87).
Where the initial allocation of goodwill is not Certain acquisitions may only be able to
completed before the end of the annual reporting be determined provisionally at the end of
period in which the business combination that gave the reporting period in which the business
rise to that goodwill occurs, the initial allocation combination occurs. For example, the cost of
must be completed before the end of the next a business combination may depend on future
annual reporting period (IAS 36, para. 84). events, such as the market price of the acquirer’s
equity instruments being offered as purchase
consideration.
The acquirer accounts for the business combination,

including any goodwill, using those provisional
values (IAS 36, para. 85). Note that, at this stage,
goodwill has not yet been allocated to a CGU.
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The provisional values must be finalised within

12 months of the acquisition date (IAS 36,
para. 85(b)). Adjustments to finalise the amount
of goodwill must be made, including allocating
that amount to a CGU (or group of CGUs),
‘before the end of the next annual reporting
period beginning after the acquisition date’
(IAS 36, para. 84).
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Goodwill is allocated to ‘the lowest level’ at This is consistent with the approach in IAS 36 by
which the entity monitors goodwill ‘for internal which goodwill is tested for impairment through
management purposes’ (IAS 36, para. 80(a)). the ‘eyes of management’ (IAS 36, para. 82).
The CGU (or group of CGUs) to which goodwill An operating segment is defined in IFRS 8
is allocated cannot be higher than an operating Operating Segments, para. 5.
segment (IAS 36, para. 80(b)).
When a CGU to which goodwill has been allocated This impacts on the carrying amount of the
includes a number of operations and one of those operation disposed of and, therefore, any gain
operations is disposed of, it may be necessary or loss on the disposal of that operation.
to consider whether a portion of the goodwill
relates to the operation that has been disposed
of (IAS 36, para. 86(a)).
This portion of goodwill is determined ‘on the

basis of the relative values … disposed of and
the portion of the CGU’ that is ‘retained, unless the
entity can demonstrate that some other method
better reflects the goodwill associated with the
operation disposed of’ (IAS 36, para. 86(b)).
Example 7.9 illustrates the allocation of goodwill to CGUs.
Example 7.9: Identifying cash-generating units for allocation

of goodwill
Entity P has two operating segments, Country A and Country B. Each segment consists of the following
four divisions:
1. Manufacturing (M)
2. Retail (R)
3. Telecommunications (T)
4. Commercial Property (C).
Entity P acquires 100 per cent of Q Ltd (Q). Q operates in Country B. Goodwill arising from the
acquisition of Q is expected to equally benefit all four divisions.
Each division has discrete cash inflows. Financial information, including the goodwill allocation from the
purchase of Q, is reviewed by management at the division level. Management also regularly reviews
the operating results of each division.
Each division is a CGU. Therefore, management is required to assess goodwill impairment for each
division separately.
The identifiable assets of Q are property, plant and equipment of $90. These assets can be allocated
on a reasonable and consistent basis to M and R.
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The goodwill of $40 arising from this acquisition is expected to equally benefit all four divisions
(CGUs): M, R, T and C. This level also corresponds with the lowest level at which the goodwill will be
monitored by P for internal management purposes. For the purposes of impairment testing under
IAS 36, the following allocations are made:
M R T C
$ $ $ $
Net assets (pre-acquisition of Q Ltd) 100 100 100 100
Net identifiable assets of Q Ltd 45 45 — —
Goodwill arising on acquisition of Q Ltd 10 10 10 10
Carrying amount of CGU 155 155 110 110
CGU groups
Assume that there was no basis on which to allocate the goodwill to each of the CGUs. In this situation,
it may be necessary to allocate goodwill to a group of CGUs. For example, the M and R CGUs
may form one group (a ‘larger’ CGU), and the T and C CGUs may form another group, or ‘larger’
CGU. The recoverable amount of the larger CGU would then be compared to its carrying amount
(including the carrying amount of goodwill allocated) and any impairment loss recognised. Assuming
that the goodwill equally benefited the two ‘larger’ CGUs, the following allocations would be made:
M R M&R T C T&C
$ $ $ $ $ $
Net assets (pre-acquisition of Q Ltd) 100 100 200 100 100 200
Net identifiable assets of Q Ltd 45 45 90 — — —
Goodwill arising on acquisition of Q Ltd — — 20 — — 20
Carrying amount of CGU(s) 145 145 310 100 100 220
Corporate assets
Corporate assets are assets other than goodwill that contribute to the future cash flows of both
the CGU under review and other CGUs. Examples of corporate assets include the head office of
an entity, information technology (IT) infrastructure and research facilities. The key characteristics
of corporate assets are that:
• ‘they do not generate cash inflows independently from other assets or groups of assets’
(similar to purchased goodwill)
• ‘their carrying amount cannot be fully attributed to the [CGU] under review’ (IAS 36, para. 100).
If it is possible to establish that the fair value less costs of disposal of a corporate asset is greater
than its carrying amount, no impairment exists. However, it may still be necessary to allocate the
carrying amount of that corporate asset to a CGU in order to correctly determine the carrying
amount of that CGU.
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If there is an indication that a corporate asset may be impaired, the recoverable amount of the
corporate asset will need to be determined as part of the CGU (or group of CGUs) to which
it belongs.
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When allocating a corporate asset to a CGU, the requirements shown in Table 7.12 apply.
Table 7.12: Requirements for allocating a corporate asset to a cash-generating unit
If the carrying amount of a corporate asset ‘can This enables the carrying amount of a CGU
be allocated to a CGU(s) on a reasonable and (or CGUs), including any portion of a corporate
consistent basis’, then do so (IAS 36, para. 102(a)). asset, to be compared to their recoverable amount
and any impairment loss recognised (IAS 36,
para. 102(a)).
If the carrying amount of a corporate asset is not These requirements are demonstrated in
allocable on a reasonable and consistent basis Example 8 (paras IE69–79) in the ‘Illustrative
to a CGU(s), then: examples’ section of IAS 36.
1. test the carrying amount of the CGU,
excluding the corporate asset, for impairment
and recognise any impairment loss (IAS 36,
para. 102(b)(i))
2. determine the smallest group of CGUs to which
the corporate asset can be allocated, test for
impairment at this level and recognise any
impairment loss (IAS 36, paras 102(b)(ii)–(iii)).
Identifying and allocating an impairment loss for a cash-

generating unit
An impairment loss exists if the carrying amount of a CGU (or group of CGUs) to which
goodwill or a corporate asset has been allocated exceeds its recoverable amount.
The process of allocating any impairment loss is as follows:

1. the carrying amount of any goodwill allocated to the CGU (or group of CGUs) is reduced—
this is consistent with the view that the asset most likely to be impaired is goodwill
2. the remainder of any impairment loss is allocated on a pro rata basis to other assets in the
CGU (or group of CGUs) on the basis of their carrying amount in that CGU (or group of
CGUs) (IAS 36, para. 104).
Note that although impairment testing to determine the extent of any impairment loss for an
asset is undertaken at a CGU level, the reductions in carrying amounts are treated as impairment
losses on individual assets included the CGU (IAS 36, para. 104).
IAS 36 places an important constraint on the amount of an impairment loss that can be allocated
to an individual asset. The standard provides that the carrying amount of an asset cannot be
reduced below the highest of:
• its fair value less costs of disposal (if these costs are measurable)
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• its value in use (if this can be determined)

• zero (IAS 36, para. 105).
This constraint means that the amount of an impairment loss that would otherwise have been
allocated to a particular asset in a CGU must be allocated on a pro rata basis to other assets of
the CGU.
The requirements for testing CGUs to which goodwill has been allocated are outlined in Example 2
(paras IE23–32) in the ‘Illustrative examples’ section of IAS 36. If you wish to explore this topic
further, you may now read this example.
Example 7.10: Impairment loss for a cash-generating unit

An entity has identified an impairment loss of $20 000 relating to one of its CGUs. The relevant details
of the carrying amount of each asset in the CGU (assets A, B, C and D), as well as the allocation of
the impairment loss to each asset based on the asset’s proportional carrying amount, are as follows:
Share of Carrying amount

Carrying amount Percentage of total impairment loss after impairment loss
Asset $ carrying amount $ $
A 30 000 23% 4 600 25 400
B 25 000 19% 3 800 21 200
C 60 000 46% 9 200 50 800
D 15 000 12% 2 400 12 600
Total 130 000 100% 20 000 110 000
However, asset C has an estimated fair value less costs of disposal of $55 000. According to para. 105(a)
of IAS 36, the extent of the impairment loss for asset C is limited to $5000 (i.e. $60 000 – $55 000).
The remaining impairment loss of $4200 (i.e. $55 000 – $50 800) that is attributable to asset C must
therefore be allocated to the remaining assets in the CGU based on those assets’ proportional carrying
amounts after the impairment loss, as determined above. Therefore:
Carrying amount Share of Carrying amount

after impairment loss Percentage of total impairment loss after impairment loss
Asset $ carrying amount $ $
A 25 400 43% 1 806 23 594
B 21 200 36% 1 512 19 688
D 12 600 21% 882 11 718
Total 59 200 100% 4 200 55 000
The requirement that any impairment loss be allocated first against any goodwill is a matter of some
controversy. For example, it can be argued that this procedure is arbitrary and fails to adequately
consider whether other identifiable assets are impaired. Other objections relate to the application of
the value in use test to goodwill. This is considered in Question 7.5.
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➤➤Question 7.5
Three members of the IASB dissented to the issuing of IAS 36. The members’ concerns are set out
in paras DO1–10 of IAS 36. What were the two key concerns raised in the members’ dissenting
opinions?
The requirements for testing CGUs to which goodwill has been allocated are illustrated in Example 7.11.
This material has been adapted from Example 2 (paras IE23–32) in the ‘Illustrative examples’ section
of IAS 36.
Example 7.11: Impairment testing for cash-generating units

to which goodwill has been allocated
At the end of 20X0, entity T acquires 100 per cent of the net assets of entity M for $10 000. M has
manufacturing plants in three countries (Country A, Country B and Country C). Each plant is considered
a CGU. Activities in each country also represent the lowest level at which the goodwill is monitored
for internal management purposes.
The goodwill is determined as the difference between the purchase price of the activities in each
country, as specified in the purchase agreement, and the fair value of the net assets (the identifiable
assets acquired and the liabilities assumed) in accordance with IFRS 3 Business Combinations. At the
end of 20X0, the allocation of the fair value of identifiable assets and goodwill to the respective CGUs
is as follows:
Allocation of Fair value of

purchase price net assets Goodwill
$ $ $
Activities in Country A 3 000 2 000 1 000
Activities in Country B 2 000 1 500 500
Activities in Country C 5 000 3 500 1 500
Total 10 000 7 000 3 000
Because goodwill has been allocated to the activities in each country, each of those activities must be
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tested for impairment once a year, or more frequently if there is any indication that they may be impaired.
The recoverable amounts (i.e. the higher of the value in use and fair value less costs of disposal)
of the CGUs are determined on the basis of value in use calculations. At the end of 20X0 and 20X1,
the value in use of each CGU exceeds its carrying amount. Therefore, the activities in each country
and the goodwill allocated to those activities are not regarded as impaired.
At the beginning of 20X2, a new government is elected in Country A. It passes legislation significantly
restricting exports of T’s main product. As a result, and for the foreseeable future, T’s production in
Country A will be cut by 40 per cent. The significant export restrictions and the resulting decreased
production require T to estimate the recoverable amount of the Country A operations at the beginning
of 20X2.
T uses straight-line depreciation over a 12-year life for the identifiable assets of Country A and
anticipates no residual value. Therefore, the carrying amounts of the assets of Country A at the
beginning of 20X2 are as follows.
Fair value of
Goodwill identifiable assets Total
$ $ $
Cost 1 000 2 000 3 000
Accumulated depreciation — (167) (167)
Carrying amount 1 000 1 833 2 833
T determines that the value in use of the Country A CGU at the beginning of 20X2 is $1360. This is
$1473 less than the carrying amount (i.e. $2833 – $1360). The fair values of the assets of Country A
are not individually determinable. As the carrying amount exceeds the recoverable amount by $1473,
T recognises an impairment loss of $1473 immediately in P&L. The first step is to reduce to zero the
carrying amount of the goodwill that relates to the Country A operations before reducing the carrying
amount of the other identifiable assets within the Country A CGU.
As at the beginning of 20X2, the carrying amounts of the assets of the Country A CGU after allocation
of the $1473 impairment loss are as follows.
Fair value of
Goodwill identifiable assets Total
$ $ $
Cost 1 000 2 000 3 000
Accumulated depreciation — (167) (167)
Carrying amount 1 000 1 833 2 833
Impairment loss (1 000) (473) (1 473)
Adjusted carrying amount — 1 360 1 360
Source: Adapted from IFRS Foundation 2017, IAS 36 Impairment of Assets,

Intangible assets
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Impairment testing for intangible assets is similar to impairment testing for goodwill, with the
following differences:
• Previously recognised impairment losses may be reversed (IAS 36, para. 114).
• Intangible assets should be allocated to individual CGUs rather than to groups of CGUs,
unless the intangible asset meets the definition of a ‘corporate asset’.
• Impairment losses are not allocated to intangible assets first. Rather, they are allocated on
a pro rata basis to all assets in the CGU (IAS 36, paras 104 and 105).
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Reversal of impairment losses

Part B of this module discussed the requirements for reversal of impairment losses for
individual assets. Those requirements apply equally to CGUs. The reversal of an impairment
loss for a CGU is allocated to the assets of the CGU, except for goodwill, on a pro rata basis
according to the carrying amounts of those assets. Those reversals are treated as reversals
of impairment losses on individual assets (refer to Part B of this module).
When a reversal of an impairment loss for a CGU is allocated, the carrying amount of an asset
cannot be increased above the lower of its recoverable amount and the carrying amount if no
impairment loss was recognised in previous years. Any remaining reversal not otherwise allocated
to the asset is allocated on a pro rata basis to the other assets of the CGU other than goodwill.
‘An impairment loss recognised for goodwill shall not be reversed in a subsequent period’
(IAS 36, para. 124). The reason for this is that any increase in goodwill would most likely be an
increase in internally generated goodwill, rather than the reversal of the impairment loss that was
previously recognised (IAS 36, para. 125). It would be difficult, or even impossible, to distinguish
events or circumstances contributing to the reversal of the previously impaired goodwill from
goodwill generated internally subsequent to the business combination that gave rise to the
acquired goodwill. This requirement is linked to the prohibition on recognising internally
generated goodwill in para. 48 of IAS 38.
Summary
Part C addressed how to identify CGUs and to determine the carrying amount of CGUs, including
how to identify corporate assets. Corporate assets are assets other than goodwill that contribute
to the future cash flows of both the CGU under review and other CGUs. Examples of corporate
assets include the head office of an entity or a division of an entity, IT infrastructure and research
facilities. The remainder of Part C considered the requirements of IAS 36 relating to the allocation
of goodwill to CGUs and the impairment testing of assets, including goodwill, as part of the
CGU to which they relate. If the carrying amount of a CGU (or group of CGUs) to which goodwill
or a corporate asset has been allocated exceeds its recoverable amount, an impairment loss
exists. The impairment loss is allocated to reduce the carrying amount of the assets of the CGU
(or group of CGUs), in the following order:
1. The carrying amount of any goodwill allocated to the CGU (or group of CGUs) is reduced.
2. The other assets of the CGU (or group of CGUs) are allocated on a pro rata basis based on
the carrying amount of each asset in the unit.
Part D now considers the disclosure requirements of IAS 36.

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Part D: IAS 36 Impairment of Assets —

disclosure
Introduction
The disclosures required by IAS 36 regarding impairment are extensive. They can be grouped
into the following two broad categories:
1. disclosures that are designed to inform users of financial reports about actual impairment
losses that have occurred during the reporting period and any reversals of impairment losses
2. disclosures of the estimates that are used to measure the recoverable amounts of CGUs
that contain goodwill or indefinite life intangibles, i.e. those intangible assets that have
‘no foreseeable limit to the period over which the asset is expected to generate net cash
flows for the entity’ (IAS 38, para. 88).
The disclosures in each of these categories are discussed below.
Disclosures of impairment losses and reversals

IAS 36 requires numerous disclosures when an entity recognises an impairment loss in its financial
report. For example, for each class of assets, the financial report must disclose the following:
(a) the amount of impairment losses recognised in profit or loss during the period and the line
item(s) of the statement of comprehensive income in which those impairment losses are included;
(b) the amount of reversals of impairment losses recognised in profit or loss during the period and
the line item(s) of the statement of comprehensive income in which those impairment losses
are reversed;
(c) the amount of impairment losses on revalued assets recognised in other comprehensive
income (equity) during the period; and
(d) the amount of reversals of impairment losses on revalued assets recognised in other
comprehensive income during the period (IAS 36, para. 126).
These disclosures can be combined with those required by other IFRSs. For example, disclosures
regarding impairment losses (or reversals) can be included as reconciling items in the reconciliation
of the carrying amount of each class of property, plant and equipment, at the beginning and end
of the period, required by para. 73(e) of IAS 16.
An entity that reports segment information under IFRS 8 is required to disclose the following
for each reportable segment:
(a) the amount of impairment losses recognised in profit or loss and in other comprehensive income
during the period; and
(b) the amount of reversals of impairment losses recognised in profit or loss and in other
comprehensive income during the period (IAS 36, para. 129).
For an individual asset or CGU in respect of which an impairment loss has been recognised,
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or reversed, during a period, the following disclosures are required by IAS 36 (para. 130):
• events and circumstances (e.g. internal or external to the entity) that resulted in the need
for the impairment loss (or reversal)
• the amount recognised or reversed
• the nature of the impaired asset and, for an entity that reports segment information
under IFRS 8, the reportable segment to which the asset has been allocated
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• for a CGU:
–– a description of the CGU (e.g. whether it is a product line or geographical area)
–– the amount recognised by class of assets and, for an entity that reports segment
information under IFRS 8, the amount recognised by reportable segment
–– if the assets that make up a CGU have changed since the last time the recoverable
amount of that CGU was estimated, a description of how the composition of assets has
changed and the reasons for the change
• the recoverable amount of the asset or CGU and whether this is based on fair value less costs
of disposal or value in use
• if recoverable amount is based on fair value less costs of disposal:
–– details regarding the fair value measurement (e.g. the level of the fair value hierarchy
in IFRS 13 to which the fair value measurement is categorised and, for certain levels within
that hierarchy, key assumptions made in estimating fair value)
• if recoverable amount is based on value in use, the discount rate(s) used in estimating both
the current and previous (if any) value in use.
Disclosures of estimates used to measure recoverable amounts

in cash-generating units
When an entity has goodwill or intangible assets with an indefinite useful life, IAS 36 requires
significant additional disclosures. This reflects the greater level of uncertainty surrounding
the recoverable amount of these assets. Disclosures include the key assumptions made
by management in estimating the future cash flows of such assets. The provision of such
disclosures may involve management exercising high levels of professional judgment.
ASIC’s review of the December 2015 financial reports of Australian entities indicates the
corporate regulator’s concern that a number of entities are not making the required disclosures,
including key assumptions, such as discount rates and growth rates, and the valuation
techniques and inputs used to determine fair value (ASIC 2016).
Summary
IAS 36 includes requirements for extensive disclosures of impairment losses, including estimates
used to measure the recoverable amount of CGUs containing goodwill or indefinite useful
life intangibles.
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Review
This module examined the procedures set out in IAS 36 for ensuring that assets are not carried
in excess of their recoverable amounts. Impairment testing is critical to financial reporting,
particularly in a changing economic environment. As noted by ASIC (2015):
Financial reports should provide useful and meaningful information for investors and other users of
those financial reports so that they can be confident and informed in making investment and other
decisions.
Non-financial assets are often significant assets of a company. The value attributed to these assets
may affect not only the company’s reported financial position, but also its reported performance.
Part A provided an introduction to the impairment of assets, including the key issues that need
to be resolved in specifying impairment requirements. Asset values and impairment calculations
are a consistent focus area for regulators, including ASIC, when monitoring financial reports.
The scope of the impairment requirements set out in IAS 36 are seen as being applicable to a
broad range of non-financial assets. With the exception of goodwill and certain intangible assets,
IAS 36 allows assets first to be reviewed for indications of impairment before a formal estimate
of recoverable amount is made (assuming an indication of impairment exists).
Part B examined how IAS 36 prefers that recoverable amount be estimated on an individual
asset basis. The detailed requirements for measuring the recoverable amount of an asset were
then considered. The value in use method of determining recoverable amount was seen as being
potentially more difficult to estimate than fair value less costs of disposal. Part B also examined
the requirements of IAS 36 that must be met to recognise an impairment loss on an individual
asset or reversals of previous impairment losses.
In practice, the recoverable amount may only be determinable for groups of assets (referred to as
CGUs) rather than for individual assets. The identification of CGUs, and the challenges associated
with testing corporate assets and goodwill for impairment, were considered in Part C.
Part D looked at the extensive disclosures specified by IAS 36, which must be made in relation
to actual impairment losses, and the estimates used to measure the recoverable amount of
CGUs containing goodwill or indefinite life intangibles. These disclosures continue to attract
the interest of corporate regulators.
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Suggested answers
Suggested answers
Question 7.1
(a) The asset has a history of profitable use within A Ltd’s operations and is currently profitable.
However, the evidence from internal reporting indicates the cash outflows are significantly
higher than those originally budgeted. According to para. 12(g) of IAS 36, this is an indication
that the asset may be impaired. Therefore, A Ltd should make a formal estimate of the
recoverable amount of the asset.
(b) The announcement by one of B Ltd’s competitors that it had developed a new generation
of computer chips, which would result in a 15 per cent reduction in the cost to manufacture
the chips, constitutes a significant adverse change in the technological environment in which
B Ltd operates. According to para. 12(b) of IAS 36, this is an indication that the assets of B Ltd
may be impaired. Therefore, B Ltd should make a formal estimate of the recoverable amount
of the assets used to manufacture computer chips for use in domestic appliances.
(c) C Ltd expects to be able to compensate for the loss of market share in the gaming industry by
diversifying into hospitality and entertainment activities. However, the assets of C Ltd that are
dedicated to gaming activities may potentially be impaired as a result of the recent government
regulations that will likely increase competition in the sector. According to para. 12(b) of IAS 36,
this is an indication that the assets of C Ltd may be impaired. Therefore, C Ltd should make a
formal estimate of the recoverable amount of the assets used in gaming activities.
(d) The market capitalisation (net worth) of D Ltd at its most recent reporting date ($50m)
exceeds the carrying amount of D Ltd’s net assets at this date ($47m). Therefore, on the
basis of market capitalisation, there is no need for D Ltd to make a formal estimate of
the recoverable amount of its assets.
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(e) Although E Ltd was not directly affected by the natural disaster, many of its suppliers have
ceased operations indefinitely. As a result, E Ltd’s plant is operating at only half its capacity.
This indicates the economic performance of the asset would be worse than expected.
This is because the cash inflows from the use of the plant will be significantly lower than
expected. The assets of E Ltd may potentially be impaired as a result of this change. According
to para. 12(g) of IAS 36, this is an indication that the assets of B Ltd may be impaired. Therefore,
E Ltd should make a formal estimate of the recoverable amount of the assets in Country X.

Question 7.2
The IASC primarily objected to the IAS 36 definition of ‘recoverable amount’ based on the sum
of undiscounted cash flows expected to be derived from an asset for the following reasons:
• It ignores the time value of money.
• Measurements that consider the time value of money are more relevant to resource allocation
decisions made by investors, other external users of financial statements and management.
• Discounting techniques are well understood by many entities.
• Discounting is already required for other financial statement items.
• Entities are better served if they are provided with timely information regarding whether their
assets will generate a return that at least compensates for the time value of money (IAS 36,
para. BCZ13).
The IASC primarily objected to a definition of ‘recoverable amount’ based on the fair value
of an asset for the following reasons:
• It refers to the market’s expectations of the recoverable amount of an asset rather than
to a reasonable estimate made by the entity itself. For example, in some cases, an entity
may have superior information than the market about the future cash flows expected to be
derived from an asset. Further, an entity may intend to use an asset in a manner that differs
from the best use of the asset that is assumed by the market.
• Market values, as a means to estimate fair value, presume that an entity is a willing seller.
In some cases, an entity may be unwilling to sell an asset because it believes that it can
derive greater service potential from the continuing use of the asset in the entity rather
than from selling it.
• It does not reflect the principle that, when the recoverable amount of an asset is assessed,
it is more relevant to consider what an entity can expect to recover from an asset
(IAS 36, para. BCZ17).
The IASC primarily objected to the IAS 36 definition of ‘recoverable amount’ based on the value
in use of the asset for the following reasons:
• If the net selling price (i.e. fair value less costs of disposal) is greater than the value in use,
rational management will dispose of the asset. The definition of ‘recoverable amount’
should reflect this commercial reality.
• To the extent that the net selling price exceeds the value in use, and when management
decides to retain the asset, the additional loss falling on the entity (the difference between
the net selling price and value in use) should be allocated to future periods consistent with
management’s decision to retain the asset in each of those periods (IAS 36, para. BCZ22).

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Question 7.3
Calculation of the value in use of the machine owned by East Ltd (East) includes the projected
cash inflows (i.e. sales income) from the continued use of the machine and projected cash
outflows that are necessarily incurred to generate those cash inflows (i.e. cost of goods sold).
Additionally, projected cash inflows include $80 000 from the disposal of the asset in 20X9.
Cash outflows include routine capital expenditures of $50 000 in 20X7. Note cash flows do not
include financing interest (i.e. 10%), tax (i.e. 30%) and capital expenditures to which East has not
yet committed (i.e. $100 000); they also do not include any savings in cash outflows from these
capital expenditures, as required by IAS 36.
The cash flows (inflows and outflows) are presented below in nominal terms. They include an
increase of 3 per cent per annum to the forecast price per unit (B), in line with forecast inflation.
The cash flows are discounted by applying a discount rate (8%) that is also adjusted for inflation.
Value in
Year ended 31.12.X5 31.12.X6 31.12.X7 31.12.X8 31.12.X9 use
Quantity (A) 10 000 10 500 11 025 11 576 12 155
Price per unit (B) $200 $206 $212 $219 $225
Estimated cash $2 000 000 $2 163 000 $2 337 300 $2 535 144 $2 734 875
inflows (C = A × B)
Misc. cash inflow: $80 000

disposal proceeds
(D)
Total estimated $2 000 000 $2 163 000 $2 337 300 $2 535 144 $2 814 875
cash inflows
(E = C + D)
Cost per unit (F) $160 $162 $165 $168 $171
Estimated cash ($1 600 000) ($1 701 000) ($1 819 125) ($1 944 768) ($2 078 505)
outflows
(G = A × F)
Misc. cash outflow: ($50 000)

maintenance costs
(H)
Total estimated ($1 600 000) ($1 701 000) ($1 869 125) ($1 944 768) ($2 078 505)
cash outflows
(I = G + H)
Net cash flows $400 000 $462 000 $468 175 $590 376 $736 370
(J = E – I)
Discount factor (1/1.081) = (1/1.082) = (1/1.083) = (1/1.084) = (1/1.085) =

8% (K) 0.9259 0.8573 0.7938 0.7350 0.6806
Discounted future $370 360 $396 073 $371 637 $433 926 $501 173 $2 073 169
cash flows
(L = J × K)
MODULE 7

Question 7.4
Suggested responses are based on Example 1 in the Illustrative Examples section of IAS 36.
(a) In identifying whether Store X is a CGU, the following are considered:

(i) Internal management reporting is organised to measure performance on a store-by-
store basis.
(ii) The business is run on a store-by-store profit basis or on a regional or city basis.
All M’s stores are in different neighbourhoods and probably have different customer bases.
So, although X is managed at a corporate level, X generates cash inflows that are largely
independent of those of M’s other stores. Therefore, it is likely that X is a CGU.
(b) Case 1
X could sell its products in an active market, thereby generating cash inflows that would be
largely independent of the cash inflows from Y. Therefore, it is likely that X is a separate CGU,
although part of its production is used by Y.
It is likely that Y is also a separate CGU. Y sells 80 per cent of its products to customers
outside the entity. Therefore, its cash inflows can be regarded as largely independent.
Internal transfer prices do not reflect market prices for X’s output. Therefore, in determining
the values in use of both X and Y, the entity adjusts financial budgets and forecasts to
reflect management’s best estimate of future prices that could be achieved in arm’s length
transactions for X’s products that are used internally.
Case 2
It is likely that the recoverable amount of each plant cannot be assessed independently
of the recoverable amount of the other plant because:
(a) The majority of X’s production is used internally and cannot be sold in an active market.
As such, the cash inflows of X depend on the demand for Y’s products. Therefore,
X cannot be considered to generate cash inflows that are largely independent
of those of Y.
(b) The two plants are managed together.
As a consequence, it is likely that plants X and Y form the smallest group of assets that
generates cash inflows that are largely independent.

MODULE 7
Question 7.5
Three members of the IASB dissented from the decision to issue IAS 36 because of their concerns
about the impairment test in IAS 36 for goodwill. Their concerns arose particularly in relation to the
merger of an acquired business with an acquirer’s pre-existing operations.
A key concern cited relates to the failure of the impairment test to distinguish between the benefits
provided by the acquirer’s pre-existing internally generated goodwill at the time of the acquisition
and the benefits provided by the purchased goodwill. As a result, the acquirer’s pre‑existing
internally generated goodwill provides a ‘shield’ against impairment of the purchased goodwill.
A further shield against impairment is also provided by internally generated goodwill that is
generated subsequent to the acquisition. Interestingly, the dissenting members did not offer
views as to how such internally generated goodwill could be measured.
Another key concern cited relates to the failure of the impairment test to incorporate a subsequent
cash flow test. Under this test, actual cash flows are required to be substituted for estimated cash
flows, which were estimated when a past impairment test occurred. An impairment loss has to be
recognised if the actual cash flows would have created an impairment loss for goodwill.
MODULE 7
MODULE 7
References | 661
References
References
ASIC (Australian Securities & Investments Commission) 2015, ‘Impairment of non-financial assets:
Materials for directors’, Information Sheet 203, accessed November 2017, http://asic.gov.au/
regulatory-resources/financial-reporting-and-audit/directors-and-financial-reporting/impairment-
of-non-financial-assets-materials-for-directors/.
ASIC (Australian Securities & Investments Commission) 2016, ‘16-205MR ASIC review of
31 December 2015 financial reports’, 28 June, accessed November 2017, http://asic.gov.au/
about-asic/media-centre/find-a-media-release/2016-releases/16-205mr-asic-review-of-31-
december-2015-financial-reports/.
ASIC (Australian Securities & Investments Commission) 2017, ‘17-162MR ASIC calls on preparers
to focus on the quality of financial report information’, 31 May, accessed November 2017,
http://asic.gov.au/about-asic/media-centre/find-a-media-release/2017-releases/17-162mr-asic-
calls-on-preparers-to-focus-on-the-quality-of-financial-report-information/.
Ernst & Young 2008, ‘Testing for impairment during financial crises and recession’, IFRS Outlook,
October.
Ernst & Young 2010, Impairment Accounting—The Basics of IAS 36 Impairment of Assets,
EYGM Limited, accessed July 2016, http://www.ey.com.
Grant Thornton 2014, Impairment of Assets: A Guide to Applying IAS 36 in Practice, March,
accessed July 2016, www.grantthornton.com.au.
Optional reading
Ernst & Young 2011, IAS 36 Impairment Testing—Practical issues, EYGM Limited, accessed July
MODULE 7
2016, http://www.ey.com.
IFRS Foundation 2017, 2017 IFRS Standards, IFRS Foundation, London.

MODULE 7
FINANCIAL REPORTING
Appendix
Contents
Techworks Ltd: Example financial statements for the
year ended 30 June 2016 665
Statement of profit or loss and other comprehensive income 666
Statement of financial position 667
Statements of changes in equity 668
Statement of cash flows 669
Notes to the financial statements 670
APPENDIX
APPENDIX | 665
Appendix
Study guide
Techworks Ltd: Example financial statements

for the year ended 30 June 2016
The financial statements in this appendix are based on a fictional business, Techworks Ltd,
and should be taken as an example only.
The Techworks Ltd financial statements support activities and questions in Modules 2, 3 and 7.
APPENDIX
Techworks Ltd: Statement of profit or loss

and other comprehensive income for the year
ended 30 June 2016
Notes 2016 2015
$’000 $’000
Continuing operations
Revenue—sale of goods 2 687,950 653,620
Cost of sales of goods (412,512) (392,139)
Gross profit 275,438 261,481

Services revenue 2 1,650,191 1,486,800
Other income 2 7,678 6,384
Administrative expenses 32,473 22,481

Depreciation and amortisation 3 11,475 9,879
Employee benefits expense 3 1,235,923 1,139,920
Marketing and promotions 45,215 48,905
Occupancy 3 44,634 40,512
Project expenses 68,921 124,857
Research and development 26,923 31,865
Other expenses 2,696 2,119
Operating profit
465,047 334,127
Finance income 3 (1,226) (613)

Finance costs 3 5,651 3,737
Finance costs—net 3 4,425 3,124
Profit before income tax 460,622 331,003

Income tax (expense)/benefit 5 137,969 98,631
Profit for the period 322,653 232,372
Profit is attributable to:

Owners of Techworks Limited 322,653 232,372
for the period 322,653 232,372
The above consolidated statement of profit or loss and other comprehensive income is to be read
in conjunction with the attached notes.
APPENDIX
APPENDIX | 667
Techworks Ltd: Statement of financial position

as at 30 June 2016
Notes 2016 2015
$’000 $’000
ASSETS
Current assets
Cash and cash equivalents 6 70,070 30,662
Trade and other receivables 7 308,829 225,740
Contract assets 8 173,000 68,483
Inventories 9 9,522 11,634
Total current assets 561,421 336,519
Non-current assets
Trade and other receivables 7 39,234 41,716
Property, plant and equipment 10 196,075 150,822
Intangible assets 11 57,458 55,174
Total non-current assets 292,767 247,712
Total assets 854,188 584,231
LIABILITIES
Current liabilities
Trade and other payables 12 69,412 54,963
Contract liabilities 13 9,300 47,508
Borrowings 17 32,850 23,816
Current tax liabilities 5 128,369 100,837
Employee benefit obligations 14 9,319 7,065
Provisions 15 18,023 7,761
Deferred revenue 16 14,120 12,043
Total current liabilities 281,393 253,993
Borrowings 17 149,428 79,249
Employee benefit obligations 14 1,439 1,339
Deferred tax liabilities 18 19,424 9,824
Total non-current liabilities 170,291 90,412
Total liabilities 451,684 344,405
Net assets 402,504 239,826
EQUITY
Issued capital 19 34,000 24,000
Reserves 8,483 5,688
Retained profits 360,021 210,138
Total equity 402,504 239,826
The above consolidated statement of financial position is to be read in conjunction with the attached notes.
APPENDIX
Statements of changes in equity

Techworks Ltd: Statements of changes in equity
for the year ended 30 June 2016
Attributable to equity holders of Techworks Ltd
Share
based
Share payments Retained
capital reserve earnings Total
$’000 $’000 $’000 $’000
Balance at 1 July 2015 24,000 5,688 210,138 239,826
Total comprehensive income for the year 322,653 322,653
Transactions with owners in their capacity as owners

Contributions of equity, net of transactions costs and tax 10,000 10,000
Employee share schemes—value of employee services 2,795 2,795
Dividends provided or paid (172,770) (172,770)
10,000 2,795 (172,770) (159,975)
Balance at 30 June 2016 34,000 8,483 360,021 402,504
Balance at 1 July 2014 24,000 3,033 195,333 222,366

Transactions with owners in their capacity as owners

Employee share schemes—value of employee services 2,655 2,655
Dividends provided or paid (217,567) (217,567)
2,655 (217,567) (214,912)
Balance at 30 June 2015 24,000 5,688 210,138 239,826
The above consolidated statement of changes in equity is to be read in conjunction with the attached notes.
APPENDIX
APPENDIX | 669
Statement of cash flows

Techworks Ltd: Statement of cash flows for
the year ended 30 June 2016
Notes 2016 20151
$’000 $’000
Receipts from customers 2,122,837
Payments to suppliers and employees (1,842,350)
Interest received (1,226)
Income tax paid (100,837)
Net cash from operating activities 22b 180,876

Investments in financial assets 1,250
Payments for intangibles (5,820)
Payments for property, plant and
equipment (52,779)
Net cash used in investing activities (57,349)

Proceeds from borrowings 90,268
Interest on borrowings (5,651)
Share scrip issue 10,000
Dividends paid (172,770)
Net cash used in financing activities (78,153)
Net increase in cash and cash 45,374

equivalents
Cash and cash equivalents at the 22(a) 24,696

beginning of the year
Cash and cash equivalents at end of 22(a)

the year 70,070
The above consolidated statement of cash flows is to be read in conjunction with the attached notes.
1
Not completed for the purpose of this activity.
APPENDIX
Notes to the financial statements

Techworks Ltd: Notes to the financial
statements for the year ended 30 June 2016
Note Contents
1 Accounting policies
2 Revenue
3 Expenses included in net profit from continuing operations
4 Franking credits
5 Income tax
6 Cash and cash equivalents
7 Trade and other receivables
8 Contract assets
9 Inventories
10 Property, plant and equipment
11 Intangible assets
12 Trade and other payables
13 Contract liabilities
14 Employee benefits
15 Provisions
16 Deferred revenue
17 Interest bearing liabilities
18 Deferred tax liabilities
19 Issued capital
20 Segment
21 Parent entity disclosures
22 Statement of cash flows
23 Subsequent events
24 Contingent liabilities
25 Financial risk management
26 Capital risk management
27 Expenditure commitments
28 Auditors’ remuneration
29 Related party disclosures
30 Registered office
APPENDIX
APPENDIX | 671

1. Accounting policies
(a) Corporate information
The financial report of the group for the year ended 30 June 2016 was authorised for issue in
accordance with a resolution of directors on 22 August 2016. The group is a public company
limited by shares, incorporated and domiciled in Australia. The nature of the operations and
principal activities of the group are described in the Directors’ Report. (Not required for the
purposes of this activity.)
The financial statements were authorised for issue by the Directors on 22 August 2016.
The Directors have the power to amend and reissue the financial statements.
The principal accounting policies applied in the preparation of the financial statements
are set out below. The policies have been consistently applied in all the years presented,
unless otherwise stated.
The financial report is presented in Australian dollars and all values are rounded to the nearest
thousand dollars (‘$000), in accordance with ASIC Corporations (Rounding in Financial/Directors’
Reports) Instrument 2016/181, unless otherwise stated.
Comparative information has been restated where applicable to enhance comparability.
(b) Basis of accounting

The financial report is a general purpose financial report, which has been prepared in accordance
with the Corporations Act 2001*, Australian Accounting Standards* and other authoritative
pronouncements of the Australian Accounting Standards Board (AASB) and Urgent Issues
group Interpretations* and other regulatory requirements.
Compliance with IFRS

The financial report complies with Australian Accounting Standards as issued by the Australian
Accounting Standards Board (AASB) and the International Financial Reporting Standards (IFRS)
as issued by the International Financial Accounting Standards Board (IASB).
In the current year, the group has adopted all of the new and revised Standards and
Interpretations issued by the AASB that are relevant to its operations and effective for the
current annual financial reporting period. The adoption of these new and revised Standards
and Interpretations did not have any material financial impact on the amounts recognised in
the financial statements of the group, however they impacted the disclosures presented
in the financial statements.
Accounting standards issued but not effective

Certain new accounting standards and interpretations have been published that are not
mandatory for 30 June 2016 reporting periods. The group’s assessment of the impact of these
new standards and interpretations is set out below:
APPENDIX

AASB 9 Financial Instruments
AASB 9 Financial Instruments establishes principles to account for and report financial assets
and financial liabilities and introduces a new approach to accounting for hedges together with
a new approach to accounting for impairment of financial assets. The standard has a mandatory
application date for financial years commencing on or after 1 January 2018, and ‘Techworks’
expects to adopt AASB 9 on 1 July 2018. The AASB 9 impairment model requires impairment
of financial assets classified at amortised cost and contract assets (recognised and measured
under AASB 139 Revenue from Contracts with Customers) to be measured based on expected
credit losses instead of incurred credit losses, as required under AASB 139. Techworks expects
changes to the nature and extent of disclosure requirements and presentation of the financial
statements upon adoption of AASB 9 but does not expect the changes to significantly impact
the consolidated financial statements.
AASB 16 Leases
AASB 16 Leases removes the current distinction between operating and finance leases and
requires recognition of a right-to-use asset and a financial liability to pay rentals, resulting in the
recognition of tenancy leases on the balance sheet. The only exemptions from these requirements
are short-term and low-value leases. The income statement will also be affected, as operating
expenses are reclassified as interest expense and depreciation expense, affecting EBITDA
performance metrics. The new standard requires more extensive qualitative and quantitative
disclosures. The standard has a mandatory application date for financial years commencing on or
after 1 January 2019. Early adoption is allowed if AASB 15 Revenue from Contracts with Customers
has also been applied. The expected date of adoption by the consolidated entity is 1 July 2019.
There are no other standards that are not yet effective and that would be expected to have a
material impact on the consolidated entity, either in the current or future reporting periods or on
foreseeable future transactions.
Early adoption of standards

The group has elected to early adopt amendments to AASB 107 Statement of Cash Flows,
as issued in January 2016 and effective for annual periods beginning on or after 1 January 2017.
These amendments relate to the disclosure initiative requiring a cash flow reconciliation for
changes in liabilities arising from financing activities. Per AASB 107, comparative information
for preceding periods is not required when first applying the amendments.
The group has also elected to early adopt AASB 15, as issued in December 2014, which would
otherwise be mandatory, effective for annual reporting periods beginning on or after 1 January
2018. The initial application date for the group is 1 July 2014. The group has elected to apply the
standard on a full retrospective basis as permitted by AASB 15 whereby the cumulative effect
of retrospective application is recognised at the date of initial application by adjusting opening
retained profits or other relevant components of equity. Comparatives for the 30 June 2015
year have also been restated. See below for further details on the key impacts of the change
in accounting policy arising from the adoption of the new standard.1
1
Not completed for the purpose of this activity.
APPENDIX
APPENDIX | 673

Accrual accounting
The financial statements have been prepared on an accrual basis and are based on historical costs.
Going concern
The financial statements have been prepared on a going concern basis.
Significant accounting policies

The following significant accounting policies have been adopted in the preparation and
presentation of the financial statements. The accounting policies are consistent with those
applied in the prior year.
(c) Critical accounting estimates, assumptions and judgments

In the application of Australian Accounting Standards, management is required to make
judgments, estimates and assumptions about the carrying value of assets and liabilities that
are not readily apparent from other sources. The estimates and associated assumptions are
based on historical experience and various other factors that are believed to be reasonable
under the circumstances, the results of which form the basis of making the judgements.
Actual results may differ from these estimates.
The estimates and underlying assumptions are reviewed on an ongoing basis. Revisions to
accounting estimates are recognised in the period in which the estimate is revised if the revision
affects only that period or in the period of the revision and future periods.
Judgments made in the application of Accounting Standards that have significant effects on
the financial statements, and estimates with a significant risk of material adjustments in the next
year are disclosed, where applicable in the relevant notes to the financial statements.
Key judgments
(i) IT consulting services revenue
Fixed price contracts
Techworks offers consulting services to design, implement, manage and support technology
solutions to clients. Consulting services revenue is recognised when the services are provided
to clients. The proportion of total contract value (revenue) for fixed price contracts is recognised
rateably over the term of the contract, by reference to the actual labour hours provided relative
to the expected total labour hours required to fulfil the consulting contract. Where the value
of consulting services provided to a client exceeds payments received to date, Techworks
recognises a contract asset. If the payments received from a client exceed the value of
consulting services provided to date, a contract liability is recognised.
Any changes to the total contract value, forecast final costs to provide consulting services
and forecast final margin are reflected in the income statement, when the information is
provided to management.
Installation of software which is not integral to the consulting services provided and may be
performed by an external third party is accounted for as a separate performance obligation.
The revenue for installing software is measured based on stand-alone selling prices or
where stand-alone selling prices are not available, the separate performance obligations
are estimated based on expected cost plus margin.
APPENDIX

Revenue earned for the installation of hardware is recognised when the hardware is delivered,
the legal title has passed and the client has accepted ownership and control of the hardware,
at a point in time.
Cost Plus contracts

Where the contract invoices clients at an hourly rate for services provided, Techworks
recognises revenue earned in accordance with the trading terms and conditions of the
contract. The terms and conditions of Techworks’ Cost Plus contracts require monthly
invoices issued to clients to reflect services provided during the month and, also stipulate
consideration is due and payable on issue of the invoice.
Measurement of contract assets and accounts receivable

The group expects to receive payment from clients for services provided within twelve
months of the date the services are provided so does not adjust consideration receivable
from clients for the time value of money.
(ii) Sale of goods—wholesale

Revenue from the sale of technology and electrical consumables in the wholesale market is
recognised when control of the products has transferred to the wholesaler, evidenced when:
–– Consumables have been delivered to the wholesaler (where either the transfer of risks
of obsolescence and loss to the wholesaler).
–– Full discretion to price the consumables is transferred to the wholesaler.
–– The wholesaler has full discretion to choose and manage the distribution channel/(s)
where the consumables are sold to the retail market.
–– Techworks has fulfilled all obligations required, under the terms and conditions of the
transaction to the wholesaler.
Revenue from the sale of goods to wholesalers is recognised as the excess of the contract
price over the estimated volume discounts. The sales value invoiced to customers is
apportioned between revenue and a contract liability for volume discounts payable to
wholesalers; the contract liability for volume discounts is estimated based on prior
experience, using the expected value method and revenue is only recognised to the
extent that is highly probable a significant reversal will not occur.
The terms of trade with wholesale customers require full settlement of accounts within
30 days, as is common market practice so Techworks does not need to account for the time
value of money on the sale of consumables to the wholesale market.
(iii) Sale of goods—retail

Techworks distributes technology and electronic consumables through its own retail channel
and recognises revenue at the point in time the consumables are sold to customers, which is
the same time that payment in full is required from the customer.
A contract liability for refunds to customers returning goods purchased within the right of
return period of 28 days is recognised. The contract liability is recognised based on prior
experience and derived using the expected value method and only recognised when it is
highly probable that a significant reversal of the cumulative revenue recognised will not be
required. The assumptions used to estimate the contract liability are reassessed at each
reporting date.
APPENDIX
APPENDIX | 675

(iv) Allowance for doubtful debts
Included in trade receivables at 30 June 2016 are amounts receivable from a number of
debtors who have fallen outside their payment terms. Despite every effort by Techworks to
collect the outstanding amounts, monies have not yet been received, and some amounts
have been outstanding for a significant period of time. The directors believe these should
be provided for and the provision reflects these.
(v) Sale of goods—customer loyalty program

Techworks offers a loyalty program to retail customers which entitles participants to a
discount on future purchases, which constitutes a performance obligation separate from
the sale of the goods to the retail customer. The transaction price charged to the retail
customer is allocated to sales revenue recognised for the sale of the product and to the
contract liability (refer to Note 16 Deferred Revenue), based on the relative stand-alone
selling prices of each performance obligation.
The value of the contract liability/ deferred revenue is measured by estimating the stand-
alone selling price per point, based on past experience of the value of discounts redeemed
and the likelihood of redemption.
The transaction price allocated to sale of the product is measured by estimating the stand-
alone selling price of the product on the basis of retail price (excluding discounts).
The group recognises revenue when loyalty points are redeemed by customers by reducing
the contract liability / deferred revenue previously recognised at the time the customers
earned the loyalty points. The value of loyalty points is released from the contract liability/
deferred revenue at expiry date, which is 12 months from the date of sale to the customer.
(vi) Software as a service (SaaS) revenue

Software licence revenues primarily represent fees earned from granting customers licences to
use database, middleware, application and industry specific software products. For software
licence arrangements that do not require significant modification or customisation of the
underlying software, revenue is recognised for new software licences when a legally binding
arrangement has been entered into, the products are delivered, the sale price is fixed or
determinable and free of contingencies or significant uncertainties and collection is probable.
Revenues that are not recognised at the time of sale because the foregoing conditions are not
met, are recognised when those conditions are subsequently met.
‘The vast majority of our software licence arrangements include software licence updates and
product support contracts, which are entered into at the customer’s option, and the related
fees are recognised rateably over the term of the arrangement, typically one year.
–– Software licence updates provide customers with rights to unspecified software
product upgrades, maintenance releases and patches released during the term of the
support period.
–– Product support includes internet access to technical content, as well as internet and
telephone access to technical support personnel.
–– Software licence updates and product support contracts are generally priced as a
percentage of the net new software licenses fees and are generally invoiced in full
at the beginning of the support term. Substantially all of our customers renew their
software license updates and product support contracts annually.’
APPENDIX

Deferred revenue
Deferred software license updates and product support revenues represent customer
payments made in advance for support contracts that are typically billed on a per annum
basis in advance with corresponding revenues being recognised rateably over the
support periods.
Deferred services revenues include prepayments for our services business and revenues
for these services are generally recognised as the services are performed.
Deferred new software licenses revenues typically resulted from undelivered products or
specified enhancements, made in advance for time-based license arrangements and which
will be recognised rateably over the period of the arrangement.
Deferred sales commissions

Sales commissions associated with cloud offerings are deferred and the related expense
recognised over the non-cancellable term of the related contracts, which are typically one
to three years. Amortisation of deferred sales commissions is included as a component
of marketing and promotions expenses, in the consolidated statement of comprehensive
income.
(d) Segment note

Operating segments are reported in a manner consistent with the internal reporting provided
to the Chief Operating Decision Maker. Strategic decisions are made by the Senior Executive
Team (SET), being the Chief Executive Officer, the Chief Financial Officer, the Chief Operations
Officer and the Chief Customer Officer. The SET allocates resources to and assesses the financial
performance and financial position of the segments identified within the group and has been
identified as the Chief Operating Decision Maker.
(e) Basis of consolidation

The consolidated financial statements comprise the financial statements of Techworks Limited
and its subsidiaries (the group).
Subsidiaries
Subsidiaries are those entities (including structured groups) over which the group has control.
The group controls an entity when the group is exposed to, or has rights to, variable returns
from its involvement with the entity and has the ability to affect those returns through its power
to direct the activities over the entity. Subsidiaries are fully consolidated from the date on which
control is transferred out of the group. The financial statements of subsidiaries are prepared
for the same reporting period as the parent company, using consistent accounting policies.
Adjustments are made to bring into line any dissimilar accounting policies that may exist.
In preparing the consolidated financial statements, all intercompany balances and transactions,
income and expenses and profits or losses resulting from intragroup transactions have been
eliminated in full.
Investments in subsidiaries held by Techworks Limited are accounted for at cost in the separate
financial statements of the parent entity. The acquisition of subsidiaries is accounted for using
the purchase method of accounting. This method of accounting involves allocating the cost
of the business combination to the fair value of the assets acquired and the liabilities and
APPENDIX
contingent liabilities assumed at the date of acquisition.

APPENDIX | 677

The acquisition method of accounting is used to account for all business combinations,
including business combinations involving entities or businesses under common control,
regardless of whether equity instruments or other assets are acquired. The consideration
transferred for the acquisition of a subsidiary comprises the fair values of the assets transferred,
the liabilities incurred and the equity interests issued by the group. The consideration also
includes the fair value of any contingent consideration and the fair value of any pre-existing
equity interest in the subsidiary. Acquisition-related costs are expensed as incurred. Identifiable
assets acquired and any liabilities and contingent liabilities assumed in a business combination
are, with limited exceptions, measured initially at their fair values at the acquisition date.
On an acquisition by acquisition basis, the group recognises any non-controlling interest in the
acquiree either at fair value or the non-controlling interest’s proportionate share of the acquiree’s
net identifiable assets.
The excess of the consideration transferred, the amount of any non-controlling interest in the
acquiree and the acquisition date fair value of any previous equity interest in the acquiree over
the fair value of the group’s share of the net identifiable assets acquired is recorded as goodwill.
If those amounts are less than the fair value of the net asset identifiable assets of the subsidiary
acquired and the measurement of all amounts has been reviewed, the difference is recognised
directly in the profit or loss as a bargain purchase.
Where settlement of any part of cash consideration is deferred, the amounts payable in the
future are discounted to their present value as at the date of exchange. The discount rate used
is the entity’s incremental borrowing rate, being the rate at which a similar borrowing could be
obtained from an independent financier under comparable terms and conditions.
Contingent consideration is classified either as equity or a financial liability. Amounts classified

as a financial liability are subsequently remeasured to fair value with changes in fair value
recognised in profit or loss.
(f) Cash and cash equivalents

Cash and cash equivalents in the statement of financial position and statement of cash flows
comprise cash at bank and in hand and short-term deposits with an original maturity of three
months or less which are convertible to known amounts of cash and are subject to an insignificant
risk of change in value.
(g) Investments and other financial assets

Financial assets are classified into the following categories: financial assets ‘at fair value through
profit or loss’, ‘held-to-maturity investments’, ‘available-for-sale’ financial assets, and ‘loans and
receivables’. The classification depends on the nature and purpose of the financial assets and is
determined at the time of initial recognition.
Loans and receivables

Trade receivables, loans and other receivables that have fixed or determinable payments that are
not quoted in an active market are classified as ‘loans and receivables’. Loans and receivables
are measured at amortised cost using the effective interest method less impairment, and are
included in trade receivables in the statement of financial position. No interest is charged on
loans and receivables.
APPENDIX
The group does not measure any financial assets at fair value.

(h) Impairment of financial assets
Financial assets are assessed for indicators of impairment at the end of each reporting period.
Financial assets are impaired where there is objective evidence that as a result of one or more
events that occurred after the initial recognition of the financial asset, the estimated future cash
flows of the investment have been impacted. For financial assets carried at amortised cost,
the amount of the impairment is the difference between the asset’s carrying amount and the
present value of estimated future cash flows, discounted at the original effective interest rate.
The carrying amount of trade and other receivables is reduced through the use of an allowance
account. When a trade and other receivable is uncollectible, it is written off against the
allowance account. Subsequent recoveries of amounts previously written off are credited
against the allowance account. Changes in the carrying amount of the allowance account are
recognised in profit or loss.
If, in a subsequent period, the amount of the impairment loss decreases and the decrease can
be related objectively to an event occurring after the impairment was recognised, the previously
recognised impairment loss is reversed through profit or loss to the extent the carrying amount of
the investment at the date the impairment is reversed does not exceed what the amortised cost
would have been had the impairment not been recognised.
(i) Intangible assets

Intangible assets acquired separately are capitalised at cost as at the date of acquisition.
Following initial recognition, the cost model is applied to the class of intangible assets.
The useful lives of these intangible assets are assessed to be either finite or infinite.
Where amortisation is charged on assets with finite lives, this expense is taken to the
consolidated statement of comprehensive income in the expense category ‘depreciation
and amortisation’.
Research costs are expensed as incurred. An intangible asset arising from development
expenditure on an internal project is recognised only when the group can demonstrate the
technical feasibility of completing the intangible asset so that it will be available for use or sale,
its intention to complete and its ability to use or sell the asset, how the asset will generate future
economic benefits, the availability of resources to complete the development and the ability to
reliably measure the expenditure attributable to the intangible asset during its development.
Following initial recognition of the development expenditure, the cost model is applied.
Intangible assets with a finite life are tested for impairment when an indicator of impairment exists
and in the case of indefinite life intangibles annually, either individually or at the cash-generating
unit level. This requires an estimation of the recoverable amount of the cash-generating units to
which the intangible with finite life is allocated. Useful lives are also examined on an annual basis
and adjustments, where applicable, are made on a prospective basis.
Gains or losses arising from the derecognition of an intangible asset are measured as the
difference between the net disposal proceeds and the carrying amount of the asset and are
recognised in consolidated statement of comprehensive income when the asset is derecognised.
APPENDIX
APPENDIX | 679

Computer software
Costs incurred in developing products or systems that will contribute to future period financial
benefits through revenue generation and/or cost reduction are capitalised to software and
systems. Costs capitalised include external direct costs of materials and service, direct payroll
and payroll related costs of employees’ time spent on the project. Software is not currently being
amortised as it is not yet ready for use.
The group uses the straight line method of depreciating computer software at a rate within the
range of 10% to 33%.
(j) Impairment of non-financial assets

At the end of each reporting period, the company reviews the carrying amounts of its tangible
and intangible assets to determine whether there is any indication that those assets have
suffered an impairment loss. If any such indication exists, the group makes a formal assessment
of recoverable amount. Resulting adjustments are applied via an impairment adjustment in
the appropriate period and result in the appropriate period in a positive (increase) to the
depreciation charge in that same period.
The recoverable amount of plant and equipment is the higher of fair value less costs to sell and
value in use. It is determined for an individual asset, unless the asset’s value in use cannot be
estimated to be close to its fair value less costs to sell and it does not generate cash inflows
that are largely independent of those from other assets or groups of assets, in which case,
the recoverable amount is determined for the cash-generating unit to which the asset belongs.
In assessing value in use, the estimated future cash flows are discounted to their present value
using a pre-tax discount rate that reflects current market assessments of the time value of money
and the risks specific to the asset.
For an asset that does not generate largely independent cash flows, the recoverable amount is
determined for the cash-generating unit to which the asset belongs.
If any such indication exists and where the carrying values exceed the estimated recoverable
amount, the asset or cash-generating units are then written down to their recoverable amount.
The impairment loss is recognised in the consolidated statement of comprehensive income.
Intangible assets not yet available for use are tested for impairment annually and wherever there
is an indication that the assets may be impaired.
(k) Plant and equipment

Depreciation is provided on plant and equipment and is calculated on a straight-line basis over
its estimated useful life net of residual values. The estimated useful lives, residual values and
depreciation method are reviewed at the end of each reporting period.
The following depreciation rates are used in the calculation of depreciation:
Class of fixed asset Depreciation rate

Freehold buildings 5%
Plant and equipment 20% to 33.3%
Lease make good asset 20% to 37.5%
Computer network and equipment 20% to 37.5%
APPENDIX

Disposals
An item of property, plant and equipment is derecognised upon disposal or when no further
future economic benefits are expected from its use or disposal.
Any gain or loss arising on disposal of the asset (calculated as the difference between the net
disposal proceeds and the carrying amount of the asset) is included in profit or loss in the year
the asset is disposed.
(l) Trade and other payables

Trade and other payables are recognised when the Company becomes obliged to make future
payments resulting from the purchase of goods and services. The amounts are unsecured and
are usually paid within 30 days of recognition.
(m) Goods and services tax

Revenue, expenses and assets are recognised net of the amount of goods and services tax
(GST) except:
(i) where the amount of GST incurred is not recoverable from the taxation authority, it is
recognised as part of the cost of acquisition of an asset or as part of an item of expense, or
(ii) for receivables and payables which are recognised inclusive of GST, the net amount of GST
recoverable from, or payable to the taxation authority is included as part of receivables or
payables in the statement of financial position. Receivables and payables are stated with
the amount of GST included.
Cash flows are included in the statement of cash flows on a gross basis and the GST component
of cash flows arising from investing and financing activities, which is recoverable from, or payable
to, the taxation authority, are classified as operating cash flows.
(n) Provisions
Provisions for legal claims, service warranties and tenancy related obligations are recognised
when the company has a present obligation (legal, equitable or constructive) as a result of
a present obligation or past events, it is probable that an outflow of resources embodying
economic benefits will be required to settle the obligation, and a reliable estimate can be
made of the amount of the obligation. Techworks does not recognise provisions for future
operating losses.
For provisions with a large number of similar obligations, the group estimates the provision
by weighting all possible outcomes by their associated probabilities, otherwise known as the
expected value method.
The group estimates the provision for a single obligation by reference to the most likely
outcome, and calibrates this outcome for other possible outcomes.
The amount recognised as a provision is the best estimate of the consideration required to
settle the present obligation at the end of the reporting period, taking into account the risks
and uncertainties surrounding the obligation. Where a provision is measured using the cash
flows estimated to settle the present obligation, its carrying amount is the discounted present
value of those cash flows. As that discount is unwound it gives rise to an interest expense in
the statement of profit or loss and other comprehensive income.
APPENDIX
APPENDIX | 681

(o) Issued capital
Issued and paid up capital is recognised at the fair value of the consideration received by the
Company. Transaction costs arising on the issue of ordinary shares are recognised directly in
equity as a reduction of the share proceeds received.
(p) Revenue recognition

Operating revenue
The group recognises operating revenue from:
(i) Services revenues, which are earned from providing software and hardware related services,
including consulting. For further information regarding recognition and measurement of
this revenue refer to note 1 (c) (i)
(ii) Revenue from the sale of technology and electronic consumable goods is recognised
when control is transferred to a customer. For further information regarding recognition
of the sale of goods to wholesale and retail customers, refer to note 1 (c) (ii) and (iii).
(iii) Cloud and on premise software revenues, including the sale of new software licences,
which generally grant to customers a perpetual right to use database, middleware,
applications and industry specific software products and Cloud SaaS offerings,
which grant customers access to a broad range of software and related support offerings
on a subscription basis in a secure standards based cloud computing environment,
advanced customer support and education services. For further information regarding
recognition and measurement of this revenue refer to note 1 (c) (iv).
Interest
Revenue is recognised as the interest accrues (using the effective interest method, which is
the rate that exactly discounts estimated future cash receipts through the expected life of the
financial instrument) to the net carrying amount of the financial asset.
(q) Employee benefits

The provision for employee benefits arises from services rendered by employees to the end of
the reporting period. Employee benefits that are expected to be wholly settled within 12 months
of the reporting date are measured at the amounts expected to be paid when the liabilities
are settled.
Liabilities expected to be settled more than 12 months after the end of the reporting period
are measured as the present value of expected future payments. Consideration is given to
expected future wage and salary levels, experience of employee departures and periods of
service. Expected future payments are discounted using market yields at the end of the reporting
period on national corporate bonds with terms to maturity and currency that match, as closely
as possible, the estimated future cash outflows.
Superannuation
The amount charged to the statement of profit or loss and other comprehensive income in
respect of superannuation represents the contributions made by the Company to the employees’
nominated superannuation funds.
APPENDIX

(r) Income tax
Current tax
Current tax is calculated by reference to the amount of income taxes payable or recoverable in
respect of the taxable profit or loss for the period. It is calculated using tax rates and tax laws
that have been enacted or substantively enacted by the end of the reporting period. Current
tax for current and prior periods is recognised as a liability (or asset) to the extent that is unpaid
(or refundable).
Deferred tax
Deferred tax is accounted for using the liability method in respect of temporary differences
arising from differences between the carrying amount of assets and liabilities in the financial
statements and the corresponding tax base for those items.
Deferred tax assets and liabilities are measured at the tax rates that are expected to apply to the
period(s) when the assets and liabilities giving rise to them are realised or settled, based on tax
rates (and tax laws) that have been enacted or substantively enacted by the end of the reporting
period. The measurement of deferred tax liabilities and assets reflects the tax consequences that
would follow from the manner in which the Company expects, at the end of the reporting period,
to recover or settle the carrying amount of its assets and liabilities.
Tax consolidation
Techworks Limited and its 100% owned Australian resident subsidiaries have formed a tax
consolidated group with effect from 31 March 2010. Techworks Limited is the head entity of the
tax consolidated group. Members of the group have entered into a tax sharing agreement in
order to allocate income tax expense to the wholly owned subsidiaries. These tax amounts are
measured as if each entity in the tax consolidated group continues to be a standalone taxpayer
in its own right.
In addition, the agreement provides for the allocation of income tax liabilities between the
entities should the head entity default on its tax obligations. No amounts have been recognised
in the financial statements in respect of this agreement on the basis that the possibility of
default is remote.
The entities have entered into a tax funding agreement under which the wholly owned entities
fully compensate Techworks Limited for any current tax payable assumed and are compensated
by Techworks Limited for any current tax receivable and deferred tax assets relating to unused tax
losses or unused tax credits that are transferred to Techworks Limited under the tax consolidation
legislation. The tax funding agreement provides for the allocation of current taxes to members
of the tax consolidated group in accordance with their accounting profit for the period,
while deferred taxes are allocated to members of the tax consolidated group in accordance
with the principles of AASB 112 Income Taxes. Assets or liabilities arising under tax funding
agreements with the tax consolidated entities are recognised as current amounts receivable from
or payable to other entities in the group. The amounts receivable/payable under the tax funding
agreement are due upon receipt of the funding advice from the head entity, which is issued
as soon as practicable after the end of each financial year. The head entity may also require
payment of interim funding amounts to assist with its obligations to pay tax instalments.
APPENDIX
APPENDIX | 683

(s) Leases
Leases under which the Company assume substantially all the risks and benefits of ownership
are classified as finance leases. Other leases are classified as operating leases.
Operating leases
Leases where the lessor retains substantially all the risks and benefits of ownership of the asset
are classified as operating leases. Payments made under operating leases are charged to the
statement of comprehensive income on a straight line basis over the term of the lease.
(t) Borrowings
Borrowings are initially measured at fair value, net of transaction costs. Borrowings are
subsequently measured at amortised cost using the effective interest method, with interest
expense recognised on an effective yield basis.
(u) Borrowings costs

Borrowing costs are recognised as an expense in the period in which they are incurred.
(v) Comparative figures

When required by Accounting Standards, comparative figures have been adjusted to conform
to changes in presentation for the current financial year.
APPENDIX

2. Revenue
2016 2015
$’000 $’000
Continuing operations:
Revenue from operating activities
Sale of goods 687,950 653,620
Service fee income 1,650,191 1,486,800
2,338,141 2,140,420
Other income
Co-operative advertising revenue 4,795 3,984
Other income 2,883 2,400
7,678 6,384
Total revenue from continuing operations 2,345,819 2,146,804
3. Expenses included in net profit from continuing operations
2016 2015
$’000 $’000
Profit before income tax includes the following specific expenses:
Employment:
Salary and employee benefits expense 1,062,033 975,497
Contributed superannuation 105,499 100,224
Other employment costs 68,391 64,199
Total employment costs 1,235,923 1,139,920
Depreciation:
Buildings 1,650 4,541
Plant and equipment 4,541 213
Computer equipment 213 1,482
Lease make good asset 1,535 7,886
Total depreciation 7,939 14,122
Amortisation:
Software core technology 1,970 1,416
Software developed technology 1,566 1,216
3,536 2,632
Operating lease:
Rent 44,634 40,512
Finance costs:
Interest on bank overdrafts, commercial bills and loans(I) 5,377 3,597
Provisions—unwinding of discount 274 140
Total finance costs 5,651 3,737
Interest revenue on bank deposits(II) (1,226) (613)
Net finance costs 4,425 3,124
(I)
The weighted average interest rate on funds borrowed generally is 2.95% p.a. (2015: 3.49% p.a.).

(ii)
The weighted average interest rate on funds borrowed generally is 1.75% p.a. (2015: 2.00%).
APPENDIX
APPENDIX | 685

4. Franking credits
2016 2015
$’000 $’000
Balance of franking account 514,350 302,444
The above amounts represent the balance of the franking account as at the end of the
reporting period, adjusted for:
(a) franking credits that will arise from the payment of income tax
(b) franking debits that will arise from the payment of dividends
(c) franking credits that will arise from the receipt of dividends recognised as
receivables at reporting date
5. Income tax
2016 2015
$’000 $’000
(a) Income tax expense
Current tax expense/(income) 128,369 100,837
Deferred tax expense/(income) 9,600 (2,206)
Total tax expense/(income) in the statement of
comprehensive income(i) 137,969 98,631
Current tax:
Profit from continuing operations 128,369 100,837
Deferred income tax:

Decrease (increase) in deferred tax assets (5,015) (8,535)
(Decrease)/increase in deferred tax liabilities 14,615 6,329
Income tax is attributable to profit from continuing operations 9,600 (2,206)

(i)
No taxes have been recognised directly in equity.
(b) Numerical reconciliation of income tax expense to prima

facie tax payable
Profit/(loss) from continuing operations before income
tax expense 460,622 331,003
Tax at the Australian tax rate calculated at 30% (2015: 30%) 138,187 99,301
Tax effect of amounts which are not deductible (taxable)
in calculating taxable income
Research and development (2,019) (2,390)
Business development 636 679
Share based payments 839 797
Other 326 244
Income tax expense/(income) 137,969 98,631
APPENDIX

6. Cash and cash equivalents
2016 2015
$’000 $’000
Cash at bank and on hand 59,570 20,162
Short term deposits 10,500 10,500
70,070 30,662
The effective interest rate on cash deposits was 1.75% (2015: 2.00%); these deposits have
no maturity date as they are held in an interest bearing cheque account.
7. Trade and other receivables

2016 2015
$’000 $’000
Current:
Trade receivables 290,894 208,560
Provision for impairment(i) (1,963) (1,540)
288,931 207,020
Loans to other parties — —
Other receivables—current — —
Prepayments 19,898 18,720
308,829 225,740
Non-Current:
Term deposits—non-current 13,250 14,500
Other receivables—non-current 25,984 27,216
39,234 41,716

(i)
A reconciliation of the movement in the allowance for doubtful debts is shown below:
2016 2015
$’000 $’000
Opening balance 1,540 1,210
Additional provisions charged to profit or loss 423 330
Closing balance 1,963 1,540
Trade receivables have been aged according to their original due date in the below ageing
analysis, including where repayment terms for certain long outstanding trade receivables have
been renegotiated. The carrying amount of renegotiated receivables is $276,558. The carrying
value of trade receivables is considered a reasonable approximation of fair value due to the
short-term nature of the balances.
The allowance for doubtful debts has been assessed on the following basis:
• an individual account by account assessment based on past credit history
• any prior knowledge of debtor insolvency or other credit risk
• working with client manager on weekly basis to assess past due amounts to determine
their recoverability.
APPENDIX
APPENDIX | 687

An allowance has been made for estimated irrecoverable trade receivable amounts arising from
the past provision of services, determined by reference to past default experience. During the
current financial year, the allowance for doubtful debts increased by $330,061 (2015: $423,070).
These amounts relate mainly to customers experiencing financial hardships. This movement
was recognised in the statement of profit or loss. The above factors were considered when
determining whether a balance was considered to be impaired.
The maximum exposure to credit risk at the reporting date is the fair value of each class of
receivable in the financial statements. The Company does not hold any collateral as security
over any receivable balance, and as such did not take possession of any collateral.
Refer to note 25 for more information on the risk management policy of the Company.
2016 2015
Gross Allowance Net Gross Allowance Net
$’000 $’000 $’000 $’000 $’000 $’000
Current 275,208 — 275,208 199,173 — 199,173
Not more than 1 month 7,469 — 7,469 1,902 — 1,902
past due
More than 1 month 3,369 (571) 2,798 2,318 (372) 1,946
but not more than
2 months past due
More than 2 months 3,093 — 3,093 2,771 (772) 1,999
but not more than
3 months past due
More than 3 months 1,235 (872) 363 2,396 (396) 2,000
but not more than
6 months past due
More than 6 months 520 (520) — — — —
past due
TOTAL 290,894 (1,963) 288,931 208,560 (1,540) 207,020
As at 30 June 2016, trade receivables with a carrying amount of $13,723,174 (2015: $7,847,100)
were past due but not doubtful.
There are no impaired assets within other receivables and it is expected that other receivables
balances will be received when due. The above past due, but unimpaired receivables relate to
customers who have a good credit history with Techworks Limited.
8. Contract assets
2016 2015
$’000 $’000
Amounts due from customers for contract work(i) 173,000 68,483
173,000 68,483
APPENDIX

Revenue earned from contracts with clients for the design, implementation and management of
technology solutions is recognised in the income statement (refer Note 1 (c) (i) for accounting
policies adopted to recognise revenue earned from Fixed Price Contracts and Cost Plus
Contracts). The amounts recognised in the statement of financial position relate to contracts
in progress. The contract assets and contract liabilities recognised in the statement of financial
position reflect the difference between:
• costs incurred and profit recognised on contracts in progress, after deducting accumulated
losses to balance date
• progress billings to balance date.
(i)
the net balance sheet position for ongoing contracts is as follows:
2016 2015
$’000 $’000
Amounts due from customers for contract work(ii) 173,000 68,483
Amounts due to customers for contract work(ii) (4,300) (12,700)
Payments in advance, for construction contract work(iii)
168,700 55,783
The net position relates to aggregate costs incurred and 325,000 203,552
recognised profits (less recognised losses) to date
Less: progress billings (156,300) (147,769)
168,700 55,783
(ii)
The group measures the stage of completion of contracts as the relationship of the contract costs
incurred to date relative to the forecast final costs of each contract, on a contract by contract basis
(note 1 (c) (i))
(iii)
Advances paid from customers for contracts related to work not yet performed.
9. Inventories
2016 2015
$’000 $’000
Finished goods 11,956 12,469
Provision for diminution in value (2,434) (835)
Total inventories at the lower of cost and net realisable value 9,522 11,634
Inventories recognised as an expense for the year ended 30 June 2016 totalled $401,328,004
(2015: $380,154,942). This expense has been included in the cost of sales line item as a cost of
inventories. Write-downs of inventories to net realisable value recognised as an expense totalled
$1,512,729 (2015: $1,689,325).
Recognition and measurement

Inventories are valued at the lower of cost and net realisable value. Costs incurred in bringing
each product to its present location and condition are accounted for on a first in, first out (FIFO)
basis. Net realisable value is the estimated selling price in the ordinary course of business,
less the estimated costs necessary to make the sale.
APPENDIX
APPENDIX | 689

10. Property, plant and equipment
Lease
make
Freehold Freehold Plant and good Computer
2016 land buildings equipment asset equipment Total
$’000 $’000 $’000 $’000 $’000 $’000
Gross carrying amount
Balance at 1 July 2015 15,700 19,900 116,529 2,135 34,365 188,629
Additions 6,000 6,000 40,779 413 53,192
Disposals (53) 0 (53)
Impairment
Balance at 30 June 2016 21,700 25,900 157,308 2,495 34,365 241,768
Accumulated depreciation
Balance at 1 July 2015 0 (1,900) (30,293) (127) (5,487) (37,807)
Depreciation expense (1,650) (4,541) (213) (1,482) (7,886)
Disposals
Balance at 30 June 2016 (3,550) (34,834) (340) (6,969) (45,693)
Net carrying amount

As at 30 June 2016 21,700 22,350 122,474 2,155 27,396 196,075
Lease Computer
make network
Freehold Freehold Plant and good and
2015 land buildings equipment asset equipment Total
$’000 $’000 $’000 $’000 $’000 $’000
Balance at 1 July 2014 103,500 2,035 30,120 135,655
Additions 15,700 19,900 32,779 2,255 4,245 74,879
Disposals (19,750) (2,155) (21,905)
Impairment
Balance at 30 June 2015 15,700 19,900 116,529 2,135 34,365 188,629
Accumulated depreciation
Balance at 1 July 2014 (42,003) (27) (4,130) (46,160)
Depreciation expense (1,900) (3,890) (100) (1,357) (7,247)
Disposals 15,600 15,600
Balance at 30 June 2015 (1,900) (30,293) (127) (5,487) (37,807)
Net carrying amount

As at 30 June 2015 15,700 18,000 86,236 2,008 28,878 150,822
Refer to note 17 for information on non-current assets pledged as security for the group.
APPENDIX

11. Intangible assets
Software— Software— Capital
core developed work in
technology technology progress Total
$’000 $’000 $’000 $’000
Balance at 1 July 2015 32,769 48,000 719 81,488
Additions 3,681 3,681
Internal development 2,139 2,139
Balance at 30 June 2016 36,450 48,000 2,858 87,308
Accumulated amortisation
Balance at 1 July 2015 (16,480) (9,834) 0 (26,314)
Depreciation expense (1,970) (1,566) (3,536)
Balance at 30 June 2016 (18,450) (11,400) 0 (29,850)
Net carrying amount

As at 30 June 2016 18,000 36,600 2,858 57,458
Software— Software— Capital

core developed work in
technology technology progress(i) Total
$’000 $’000 $’000 $’000
Balance at 1 July 2014 28,790 34,491 63,281
Additions 3,979 13,509 17,488
Internal development 719 719
Balance at 30 June 2015 32,769 48,000 719 81,488
Accumulated amortisation
Balance at 1 July 2014 (15,064) (7,200) (22,264)
Depreciation expense (1,416) (1,216) (2,632)
Balance at 30 June 2015 (16,480) (9,834) 0 (26,314)
Net carrying amount

As at 30 June 2015 16,289 38,166 719 55,174
(i)
The computer software is purchased as part of a system upgrade and is still under development. It is
expected to be completed by December 2017 and amortisation will commence during this period also.
This software is assessed as having a finite life and will be amortised over the estimated useful life of the
asset. As the asset was not in use during 2015 and 2016 the only movement has been additions.
An impairment test has been performed during the year and based on the expected net cash inflows
from the software there is no impairment loss. Sensitivity analysis on the assumptions used have shown
that there is no reasonably possible movement that would cause an impairment loss.
APPENDIX
APPENDIX | 691

12. Trade and other payables
2016 2015
$’000 $’000
Trade payables 40,608 35,282
Other payables 15,714 11,681
Amounts payable to related parties 13,090 8,000
69,412 54,963
Trade creditors and other creditors are non-interest-bearing liabilities. Trade creditor payments
are processed once they have reached 30 days from the date of invoice for electronic funds
transfer payments or cheque payment, or 30 days from the end of the month of invoice for
other payments. No interest is charged on trade payables.
All amounts are short term and the carrying values are considered to be a reasonable
approximation of fair value.
13. Contract liabilities

2016 2015
$’000 $’000
Amounts due to customers for contract work(i) 4,300 12,700
Advances received from customers for contract work(ii) 5,000 34,808
9,300 47,508
(i)
The amounts recognised in respect of contracts will generally be utilised within the next
reporting period.
(ii)
Advances paid from customers for contracts related to work not yet performed.
14. Employee benefits

2016 2015
$’000 $’000
Current
Employee benefits—current 9,319 7,065
Non-current
Employee benefits—non-current 1,439 1,339
The group provides for annual and long service leave accrued for the benefit of employees at
balance date; annual leave and unconditional entitlements to long service leave are classified as
current liabilities, as these provisions are expected to be settled within twelve months of balance
date. The entire amount of the provision is presented as current, since the group does not have
an unconditional right to defer settlement for any of these obligations. However, based on past
experience, the group does not expect all employees to take the full amount of accrued leave
or require payment within the next 12 months. The following amounts reflect leave that is not
expected to be taken or paid within the next 12 months:
2016 2015
$’000 $’000
Annual leave 724 693
Long service leave accrued for the benefit of employees which will not be used or taken in the
next twelve months and for which the group has an unconditional right to defer payment beyond
APPENDIX
the next twelve months has been classified as a non-current liability.


Defined contribution plans
The Company makes contributions to employee superannuation schemes, which are defined
contribution plans. The amount recognised as an expense during the year was $105,499,910
(2015: $100,224,313).
15. Provisions
2016 2015
$’000 $’000
Current
Provision for warranties 1,340 983
Make good provision 6,700 6,600
Onerous leases 1,450 0
Deferred lease expenses 220 178
Provision for legal claim 7,500 0
Provision for restructuring 813 0
18,023 7,761
Provision Make Deferred Provision

for good Onerous lease for legal Provision for Total
warranties provision leases expenses claim restructuring provisions
$’000 $’000 $’000 $’000 $’000 $’000 $’000
Gross carrying
amount
Balance at 1 July 2015 983 6,600 0 178 0 0 7,761
Additional provision 413 413
charged to plant
and equipment
Charged/(credited) to
profit or loss:
• Additional 769 1,410 513 7,500 813 11,005
provisions
recognised
• Unwinding of 47 187 40 274
discount
Amounts used during
the year (459) (500) (471) (1,430)
Balance at
30 June 2016 1,340 6,700 1,450 220 7,500 813 18,023
Gross carrying
amount
Balance at 1 July 2014 872 4,790 125 5,787
Additional provision 2,255 2,255
charged to plant
and equipment
Charged/(credited) to
profit or loss:
• Additional 810 298 1,108
provisions
recognised
• Unwinding of 42 98 140
discount
Amounts used during
the year (741) (543) (245) (1,529)
Balance at
30 June 2015 983 6,600 0 178 0 0 7,761
APPENDIX
APPENDIX | 693

Provision for warranties
Provision is made for estimated warranty claims in respect of products sold which are still under
warranty at the end of the reporting period.
These claims are expected to be settled in the next financial year.
Management estimates the provision based on historical warranty claim information and any recent
trends that may suggest future claims could differ from historical amounts.
Make good provision

In accordance with certain lease agreements, the group is obligated to restore certain leased
premises to a specified condition at the end of the lease term. The balance of the make good
provision as at 30 June 2016 represented the expected costs to be incurred in restoring the
leased premises to the condition specified in the lease.
Onerous lease costs

The group recognises a provision for onerous lease costs payable on tenanted premises where
the costs payable under the non-cancellable lease agreements exceed the benefits of the lease
contracts with the landlords, and usually arises when the group vacates the premises before
the end of the lease term. The provision is estimated as the present value of amounts the group
is presently obliged to make to landlords, after deducting any future sub-lease revenue which
will be earned on the premises. This obligation may be reduced by the revenue expected
to be earned on the lease including estimated future sub-lease revenue, where applicable.
The estimate may vary as a result of changes in the utilisation of the leased premises and
sub‑lease arrangements where applicable.
Deferred lease expenses

Deferred lease expenses represent the present value of the future lease payments that the group
is presently obliged to make under non-cancellable operating lease agreements to enable the
even recognition of lease payments as an expense on a straight-line basis over the lease term.
Provision for legal claim

A provision for legal claim has been recognised for damages payable to a customer of the
consultancy division, following an unfavourable judgment handed down against the group by
the Queensland Supreme Court in February 2016.
Provision for restructuring

The reduced demand for SaaS in regional and remote areas required a reassessment of the
size and geographic distribution of client facing staff and technology, resulting in a loss of
jobs. The provision for restructuring includes costs associated with the voluntary redundancy
compensation package of $813,123 and other direct costs associated with closure of premises,
including lease termination, of $813,123. The provision remaining on the statement of financial
position at balance date is expected to be fully utilised before 30 June 2017.
APPENDIX

16. Deferred revenue
2016 2015
$’000 $’000
Deferred revenue—SaaS(i) 4,970 4,593
Deferred revenue—loyalty points(ii) 9,150 7,450
14,120 12,043
(i)
Deferred software licence updates and product support revenues and deferred hardware support
revenues represent customer payments made in advance for support contracts that are typically billed
on a per annum basis in advance with corresponding revenues recognised rateably over the support
periods. Deferred cloud SaaS revenues generally resulted from customer payments made in advance
for cloud based service offerings that are recognised over the corresponding contract term.
(ii)
The group operates a loyalty programme where customers accumulate points for purchases made
which entitle them to discounts on future purchases. Revenue from the award points is recognised
when the points are redeemed. The amount of revenue recognised is based on the number of point
redeemed relative to the total number expected to be redeemed. Award points expire 12 months
after the date of sale.
17. Interest bearing liabilities

2016 2015
$’000 $’000
Current
Borrowings—overdraft 0 5,966
Commercial bills—current 2,450 2,450
Term loan—current 30,400 15,400
32,850 23,816
Non-current
Commercial bills—non-current 2,139 2,139
Term loan—non-current 147,289 77,110
149,428 79,249
Fair value disclosures

The fair value of current borrowings approximates their carrying amount as the impact of
discounting is not significant.
Fair values of long term financial liabilities are based on cash flows discounted using fixed
effective market interest rates available to the Company.
No fair value changes have been included in profit or loss for the period as financial liabilities
are carried at amortised cost in the statement of financial position.
APPENDIX
APPENDIX | 695

Financing facilities available 2016 2015
$’000 $’000
Total facilities
– Bank overdraft 7,500 7,500
– Commercial bills 10,000 10,000
– Term loan 200,000 100,000
217,500 117,500
Facilities used at reporting date

– Bank overdraft — 5,966
– Term loan 177,689 92,510
182,278 103,065
Facilities unused at reporting date

– Bank overdraft 7,500 1,534
– Term loan 22,311 7,490
35,222 14,435
Total facilities
– Facilities used at reporting date 182,278 103,065
– Facilities unused at reporting date 35,222 14,435
217,500 117,500
Bank overdrafts
The bank overdrafts are secured by a fixed charge over certain of the Company’s assets.
The bank overdraft facilities may be drawn at any time and may be terminated by the bank
without notice.
2016 2015
$’000 $’000
Assets pledged as security
Fixed charge—over plant and equipment(i) 196,075 150,822

(i)
Under the arrangement of the finance lease and bank borrowing facilities, all plant and equipment
of the Company has been pledged as security. The holder of the security does not have the right to
sell or re-pledge the assets.
APPENDIX

18. Deferred tax liabilities
2016 2015
$’000 $’000
The balance comprises temporary differences attributable to:
Prepayments (2,267) (1,914)
Property, plant and equipment (20,559) (6,983)
Intangible assets (10,787) (10,102)
Total deferred tax liabilities (33,613) (18,999)
Set-off of deferred tax assets, pursuant to set-off provisions:

Receivables 589 462
Inventories 730 251
Employee benefits 3,227 2,521
Deferred revenue 4,236 3,613
Make good provision 2,010 1,980
Onerous leases 435 0
Deferred lease expenses 66 53
Provision for onerous contracts 2,250 0
Provision for restructuring 244 0
Total deferred tax assets 14,189 9,175
Net deferred tax liabilities (19,424) (9,824)
Movements in deferred tax balances:

Balance at 1 July (9,824) (7,618)
Charged/(credited) to profit or loss: (9,600) (2,206)
Balance at 30 June (19,424) (9,824)
Offsetting within tax consolidated group

The group formed a tax consolidated group under the tax consolidation legislation of the parent
company and wholly owned subsidiaries, to enable the preparation and lodgement of a single
tax return for the group, instead of multiple tax returns for the individual entities within the
group. The deferred tax assets and deferred tax liabilities of entities within the tax consolidated
group have been offset in the consolidated financial statements.
Tax losses
There are no unused tax losses.
Unrecognised temporary differences

There are no unrecognised temporary differences.
APPENDIX
APPENDIX | 697

19. Issued capital
2016 2015
$’000 $’000
Share capital 34,000 24,000
The company does not have a limited amount of authorised

capital and issued shares do not have a par value.
Issued and fully paid-up ordinary shares

Balance at 1 July 24,000 24,000
Issue of/redemption of shares 10,000 —
Position at 30 June 34,000 24,000
Terms and conditions of issued capital
Ordinary shares
Ordinary shares have the right to receive dividends as declared and, in the event of winding up
the Company, to participate in the proceeds from the sale of all surplus assets in proportion to
the number of and amounts paid up on shares held.
Ordinary shares entitle their holder to one vote, either in person or by proxy, at a meeting of
the Company.
The company has 2,193,566 shares on issue, with none held in escrow.
20. Segment
(a) Description of segments
‘Management has determined the operating segments based on the reports reviewed by
the chief operating decision maker, being the strategic steering committee which consists
of the chief executive officer, the chief financial officer, the chief customer officer and the
chief operations officer that are used to make strategic decisions. No operating segments
have been aggregated to form the below reportable operating segments. This results in
the following reportable operating segments:
–– Retail IT consumables and electronics
–– SaaS ‘on demand’
–– IT consulting and implementation.
The group operates in Australia and the strategic steering committee do not evaluate the
performance or position of the business from a geographic perspective.’
APPENDIX

(b) Segment information provided to the chief operating decision maker
Detailed below is the information provided to the chief operating decision maker for
reportable segments.
Retail IT IT consulting Inter-

consumables SaaS ‘on- and Total segment/
Segment and electronics demand’ implementation segments unallocated Consolidated
Segment revenue 687,950 730,191 920,000 2,338,141 0 2,338,141
Inter-segment sales
Other income 6,355 982 341 7,678 0 7,678
Total segment revenue

and other income 694,305 731,173 920,341 2,345,819 0 2,345,819
Segment EBITDA 60,296 222,027 194,199 476,522 0 476,522
Segment depreciation
and amortisation 7,886
Segment EBIT result 468,636
Net finance costs 4,425
Total segment net profit 464,211
before tax
Segment income tax
expense 137,968
Profit for the period 326,243
The strategic steering committee assesses the performance of the operating segments based on
EBITDA. No reporting is currently provided to the strategic steering committee with respect to
total segment assets or liabilities as these items are managed at a consolidated group level only.
The amounts disclosed for total segment assets are an allocation of total consolidated assets
based on the operations of the segments and the physical locations of the assets.
Reportable segment assets are reconciled to total assets as follows:
2016 20151
$’000 $’000
Retail IT consumables and electronics 9,156
SaaS ‘on-demand’ 172,564
IT consulting and implementation 220,784
402,504
1
Comparatives not completed for the purpose of this activity.
APPENDIX
APPENDIX | 699

21. Parent entity disclosures
2016 2015
$’000 $’000
Result of parent entity
Profit for the year (181,059) (125,699)
Other comprehensive income 2,795 2,655
Financial position of parent entity at year end

Current assets 20,591 19,561
Non-current assets 48,322 47,220
Total assets 68,913 66,781
Current liabilities 211,697 201,112

Non-current liabilities 247,029 236,890
Total liabilities 458,726 438,002
During the financial year ended 30 June 2016, Techworks Limited declared and paid fully franked dividends
of $172,771 (2015: $217,567).
22. Statement of cash flows

(a) Reconciliation of cash
For the purposes of the statement of cash flows, cash includes cash on hand and in banks and
investments in money market instruments with terms of less than 90 days, net of outstanding
bank overdrafts. Cash at the end of the year as shown in the statement of cash flows is
reconciled to the related items in the statement of financial position as follows:
2016 2015
Notes $’000 $’000
Cash at bank and on hand 6 70,070 30,662
Bank overdraft 17 0 (5,966)
70,070 24,696
APPENDIX

(b) Reconciliation of operating profit after income tax to net cash flows
from operating activities†
Notes 2016 2015
$’000 $’000
Net profit after tax 322,653
Non-cash items
Depreciation and amortisation expense 3 11,475
Share-based payments to employees 3 2,795
Provision for lease make good 15 (413)
Non-operating activities
Term deposits 7 (1,250)
Amounts payable to related parties 12 (5,090)
Changes in assets and liabilities

(Increase)/decrease in assets
Trade and other receivables (80,607)
Other assets (102,405)
Increase/(decrease) in liabilities
Trade and other payables 14,449
Current tax liabilities 27,532
Deferred tax liabilities 9,600
Employee benefit obligations 8,006
Deferred revenue 2,077
Other liabilities (27,946)
Cash flows from operations 180,876
(c) Reconciliation of liabilities arising from financing activities
2015 Cash Non-cash 2016

$'000 flows changes $'000
Amounts payable to related parties 8,000 5,090 13,090
Borrowings—overdraft 5,966 (5,966) 0

Commercial bills 2,450 — — 2,450
Term loan 15,400 15,000 — 30,400
Short-term borrowings 23,816 15,000 (5,966) 32,850
Commercial bills 2,139 — — 2,139

Term loan 77,110 70,179 — 147,289
Long-term borrowings 79,249 70,179 — 149,428
Total liabilities arising from financing activities 111,065 90,269 5,966 195,368
APPENDIX
APPENDIX | 701

23. Subsequent events
(a) Refinancing of borrowings
The group renegotiated its existing loan finance facility in August 2016; the total amount
available under the facility was increased by $60 000 000, which is expected to be drawn
down over the next 12 months. The renegotiated facility will be repaid in three annual
instalments, commencing in August 2021.
(b) Recommended dividends

Refer to note for the final dividend recommended by directors, to be paid on 17 October 2016.
(c) Other events

Other than disclosed above and elsewhere in the financial statements of the Company,
no other matter or circumstances has arisen since the end of the financial year that
has significantly affected or may significantly affect the operations, results or state of
the contingent liabilities.
24. Contingent liabilities

The Company has no contingent liabilities as at 30 June 2016 (2015: nil).
APPENDIX

25. Financial risk management
Financial risk management strategy
The financial risks arising from the group’s operations comprise market, liquidity and credit risk.
These risks arise in the normal course of business, and the group manages its exposure to them
in accordance with the group’s risk management strategy. The objective of the strategy is to
support the delivery of the group’s financial targets while protecting its future financial security
and flexibility by taking advantage of the natural scale, diversity and flexibility of the group’s
operations and activities.
The group’s risk management is carried out by the finance department under the policies
approved by the Board of Directors. The Board provides written principles for overall risk
management, as well as policies covering specific areas such as foreign exchange risk,
interest rate risk, credit risk and investment of excess liquidity.
It is, and has been, throughout the period, the group’s policy that no trading in financial
instruments shall be undertaken, as the main risks arising from the group’s financial instruments
are cash flow interest rate risk, liquidity risk and credit risk. The group’s exposure to foreign
exchange risk is insignificant. The group is not exposed to commodity or equity price risk.
The Company does not actively engage in the trading of financial assets for speculative
purposes nor does it write options. The most significant financial risks which the Company is
exposed to are described below.
Market risk
Risk management
Foreign Credit risk Liquidity risk
framework
exchange risk Interest rate risk
Exposure arising ‘Future ‘Long-term ‘Cash and cash Borrowing and

from commercial borrowings at equivalents; other liabilities
transactions; variable rates’ trade and other
recognised receivables’
financial
instruments
(not denominated
in AUD)’
Measurement ‘Cash flow Sensitivity analysis ‘Ageing analysis; Credit limits and
forecasting; credit ratings’ retention of title
sensitivity analysis’ over goods sold
Management ‘Forward ‘Interest rate Rolling cash flow Availability of

exchange swaps (where forecasts committed
contracts (where exposure exceeds credit lines
exposure exceeds pre-specified and borrowing
pre-specified limit)’ facilities
limit)’
APPENDIX
APPENDIX | 703

(a) Market risk
(i) Interest rate risk
The group’s exposure to the risk of changes in market interest rates relates primarily to
the group’s long term debt obligations with a floating interest rate and the group’s policy
is to take advantage of the current low interest rates available in the current economic
environment. The level of debt is disclosed in note.
Techworks Limited’s borrowings, which have a variable interest rate attached, give rise
to cash flow interest rate risk.
2016 2015
Interest rate range
From – To From – To
% %
Financial assets
Cash and cash equivalents 1.7% – 2.4% 2.4% – 3.6%
Borrowings 2.5% – 3.4% 3.4% – 3.9%
The group constantly analyses its interest rate exposure. Within this analysis consideration
is given to potential renewals of existing positions, alternative financing and the mix of
fixed and variable rates.
The following sensitivity analysis is based on the interest rate exposures in existence at
the balance sheet date. At 30 June 2016, if interest rates had moved, as illustrated in the
table below, with all other variables held constant, post tax profit and equity would have
been affected as follows.
2016 2015
$’000 $’000
Judgments of reasonably possible interest rate movements
+1% (100 basis points) 153 89
–1% (100 basis points) (153) (89)
These movements in profit are due to higher/lower interest costs from variable debt and
cash reserves.
(b) Credit risk

The group only trades with recognised, credit worthy third parties and it is the group’s
policy that all customers who wish to trade on credit terms are subject to credit verification
procedures and risk limits are set for each individual customer in accordance with the
group’s policies.
APPENDIX

In addition, receivables balances are monitored on an ongoing basis with the result that the
group’s exposure to bad debts is not significant.
With respect to credit risk arising from the other financial assets of the group, which comprise
cash and cash equivalents, the group’s exposure to credit risk arises from default of the
counter party, with a maximum exposure equal to the carrying amounts of these instruments.
The group only trades only with recognised, credit worthy third parties and as such collateral
is not requested nor is it the group’s policy to securitise its trade and other receivables.
The maximum exposure to credit risk is the carrying value of the financial assets as disclosed
in Note 7.
(c) Liquidity risk analysis

Prudent liquidity risk management implies maintaining sufficient cash and the availability of
funding through an adequate amount of committed credit facilities to meet obligations when
due. Due to the dynamic nature of the underlying businesses, the group maintains flexibility
in funding by maintaining availability under committed credit lines.
Management monitors rolling forecasts of the group’s liquidity reserve and cash and cash
equivalents on the basis of expected cash flows. In addition, the group’s treasury management
policy involves projecting cash flows and considering the level of liquid assets necessary to
meet these, monitoring balance sheet liquidity ratios against internal and external regulatory
requirements and maintaining debt financing plans.
The table below reflects all contractually fixed pay-offs and receivables for settlement,
repayment and interest resulting from recognised financial assets and liabilities as at 30 June
2016. No derivative financial instruments are held and for other obligations the respective
undiscounted cash flows for the respective upcoming fiscal years are presented. Cash flows
for financial assets and liabilities without fixed amount or timing are based on the conditions
existing at 30 June 2016.
The remaining contractual maturities of the group’s financial liabilities are:

2016 Interest rate < 1 year 1–5 years > 5 years Carrying
% $’000 $’000 $’000 amount
Term loan 2.95 30,400 73,645 73,645 177,689
Commercial bills 2.95 2,450 2,139 2,450
Trade and other payables n/a 69,412 69,412
Total financial liabilities 102,262 75,784 73,645 249,551

2015 Interest rate < 1 year 1–5 years > 5 years Carrying
% $’000 $’000 $’000 amount
Bank overdraft 5,966 5,966
Term loan 3.49 15,400 38,555 38,555 92,510
Commercial bills 3.49 2,450 2,139 0
Trade and other payables n/a 54,963 54,963
Total financial liabilities 78,779 40,694 38,555 153,439
APPENDIX
APPENDIX | 705

(d) Fair value estimation
The carrying value less impairment provision of trade receivables and payables is a reasonable
approximation of their fair values due to the short-term nature of trade receivables.
26. Capital risk management

(a) Risk management
The group’s objectives when managing capital are to safeguard their ability to continue as a
going concern, so that they can continue to provide returns for shareholders and benefits for
other stakeholders, and maintain an optimal capital structure to reduce the cost of capital.
In order to maintain or adjust the capital structure, the group may adjust the amount of
dividends paid to shareholders, return capital to shareholders, issue new shares or sell assets
to reduce debt.
The group monitors overall capital on the basis of the gearing ratio. The ratio is calculated
as net debt divided by total capital. Net debt is calculated as total borrowings less cash and
cash equivalents. Total capital is calculated as equity as shown in the consolidated balance
sheet plus net debt.
During 2016, the group’s strategy, which was unchanged from 2015, was to ensure that the
gearing ratio remained below 50%. The target range excludes the short-term impact of
acquisitions. The gearing ratios at 30 June 2016 and 30 June 2015 were as follows:
2016 2015
$’000 $’000
Total borrowings 182,278 103,065
Less: Cash and cash equivalents (70,070) (30,662)
Net debt 112,208 72,403
Total equity 402,504 239,826
Total capital 514,712 312,229
Gearing ratio 22% 23%
The group monitors ongoing capital on the basis of the fixed charge cover ratio. The ratio
is calculated as earnings before net finance costs, income tax, depreciation, amortisation and
store and rental expense divided by fixed charge obligations (being finance costs and store
and distribution centre rental expenses). Rental expenses are calculated net of straight line
lease adjustments, while finance costs exclude non-cash mark to market losses or gains on
interest rate swaps.
APPENDIX

During 2016, the group’s strategy, which was unchanged from 2015, was to maintain a fixed
charge cover ratio of around 2.0 times. The fixed charge cover ratios at 30 June 2016 and
30 June 2015 were as follows:
2016 2015
$’000 $’000
Profit 322,653 232,372
Add
Taxation expense 137,969 98,631
Depreciation and amortisation 11,475 9,879
EBITDA 476,522 344,006
Rental expense 44,634 40,512
EBITDAR 521,156 384,518
Rental expense 44,634 40,512
Fixed charges 49,059 43,636
Fixed charge cover ratio 10.62 8.81
Ratio of fixed charges to EBITDAR 9.41% 11.35%
Net debt to EBITDA ratio 0.235 0.210
(b) Loan covenants

The group has complied with the financial covenants of its borrowing facilities during the
2016 and 2015 years. Under the terms of the major borrowing facilities, the group is required
to comply with the following financial covenants:
(a) the gearing ratio must not exceed 50%
(b) the ratio of fixed charges to EBITDAR must be not more than 15%.
27. Expenditure commitments

Operating leases
Operating leases relate to branch premises with lease terms of up to 5 years plus an option to
extend a further 5 years. All operating leases contain market rent review clauses when option
to renew is exercised.
2016 2015
$’000 $’000
Lease expenditure commitments
Operating leases (non-cancellable)
Minimum lease payments
Not later than one year 42,851 41,295
Later than one year but not later than five years 315,777 358,628
Total minimum payments 358,628 399,923
Other expenditure commitments(i)

Not later than one year 17,599 —
Later than one year but not later than five years 3,285 —
Recognised as a liability 20,884 —
(i)
The group is refurbishing its head office and has signed a contract at 30 June 2016 for an external firm
to manage and perform the refurbishment works. The works are due to be completed over a two-year
period and instalments will be paid equally over this period.
APPENDIX
APPENDIX | 707

28. Auditor’s remuneration
2016 2015
$’000 $’000
Amounts received or due and receivable by the auditors for:
Auditing the financial statements of the Company 754,000 698,000
Total remuneration of auditors 754,000 698,000
29. Related party disclosures

(a) Controlled entities
Country of Percentage of
Name incorporation equity interest held Investment
2016 2015 2016 2015
% % $ $
Everything Electronics Australia 100 100 12 12
Pty Limited
Cloud On-Demand Australia 100 100 12 12
Pty Limited
Technology Solutions Australia 100 100 12 12
Pty Limited
Total investments in controlled entities—at cost 36 36
(b) Deed of cross guarantee

Entities subject to class order relief
Pursuant to Class Order 98/1418, relief has been granted to Everything Electronics
Pty Limited, Cloud On-Demand Pty Limited and Technology Solutions Pty Limited
from the Corporations Act requirements for preparation, audit and lodgement of their
financial reports.
As a condition of the Class Order, Everything Electronics Pty Limited, Cloud On-Demand
Pty Limited and Technology Solutions Pty Limited, entered into a Deed of Cross-Guarantee
on 11 December 2013. The effect of the deed is that Techworks Limited has guaranteed
to pay any deficiency in the event of winding up of the controlled entities or if they do not
meet their obligations under the terms of overdrafts, loans or other liabilities the subject to
the guarantee.
Closed Group Class Order disclosures

Techworks Limited and its controlled subsidiaries, as shown above, are party to the Deed of
Cross Guarantee and represent a ‘Closed Group’ for the purposes of the Class Order.
As the consolidated financial statements cover all parties to the Deed of Cross Guarantee,
no separate disclosure of consolidated information of the Closed Group has been shown.
APPENDIX

(c) Key management personnel’s remuneration
The key management personnel compensation included in ‘employee expenses’
are as follows:
Short-term employee benefits 4,963,688 4,326,001

Other long-term benefits 32,154 28,522
Post-employment benefits 471,550 410,970
Termination benefits 0 0
Share based payments 2,795,374 2,655,771
8,262,766 7,421,264
(d) Loan disclosures

During the year the Company had an unsecured amount of $609,552 (2015: $893,988)
payable to Fellofic Limited (a director related entity). This amount is non-interest bearing,
and is at call.
Loans to key management personnel(i) 296,000 —

(i)
Loans totalling $296,000 (2015: $nil) were made to key management personnel during the year.
During the year key management personnel repaid $nil (2015: $nil) of the balance
outstanding on their loan.
For all loans to key management persons, interest is payable at prevailing market rates,
currently 3% (2015: n/a%). The principal amounts are repayable by 30 June 2017. All loans
are secured by registered first mortgage over the borrower’s residences.
Interest received on the loans totalled $nil (2015: $nil). No amounts have been written down
or recorded as allowances, as the balances are considered fully collectible.
(e) Key management personnel equity holdings

None of the key management personnel hold any securities in the company.
(f) Other transactions with key management personnel

During the year, there were no other transactions with Key Management personnel or their
related entities.
(g) Transactions with other related parties

During the year, Techworks Limited has received from and provided to its wholly owned
subsidiaries, interest free loans. These loans are repayable on call. No allowance has been
made for impairment relating to amounts owed to or by related parties as payment is
expected in full. An impairment assessment is undertaken each financial year by examining
the financial position of the related party and the market in which the related party operates.
30. Registered office

Level 2, 635 Sedgefield Road
Acklam
Central Australia 9000
APPENDIX

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ISBN 978 1 921742 85 9

CPA Program team

Study guide—Subject outline

Insights for a great semester

• Important information for

Ask the expert forum

Study guide MODULE 3

Knowledge checks Study guide

Ask the expert forum Study time proportion: 10%

Study time proportion: 14%

Study guide Study guide

Knowledge checks Knowledge checks

Income taxes • Determination of goodwill

Ask the expert forum M5

Ask the expert forum

Study time proportion: 24%

Ask the expert forum MODULE 7

Study time proportion: 14%

Ask the expert forum

• What to expect in your exam Study time proportion: 10%

Detailed study session planning

Before you begin

— Study guide—Subject outline 15 mins

— Video: Insights for a great semester of study 6 mins

— Important information for candidates: IFRS® standards 1 min

— Red Book 2017: IFRS® standards selected for 5 mins

— Study and Exam Information 20 mins

— Study Companion and Exam Mark Allocations 20 mins

— Appendix (Techworks Ltd example financial statements) —

— Ask the expert forum: Frequently Asked Questions and —

1 Study guide—The role and importance of financial reporting 2 hrs

2 Study guide—The Conceptual Framework for Financial 1 hr

3 Study guide—Qualitative characteristics of useful financial 2 hrs

4 Study guide—The elements of financial statements 2 hrs

5 Study guide—Measurement of elements of financial 3 hrs

6 Study guide—Application of measurement principles in the 4.5 hrs

— Knowledge checks 36 mins

— Ask the expert forum: Module 1—The role and importance —

1 Study guide—Part A: Presentation of financial statements 4.5 hrs

2 Study guide—Part A: Presentation of financial statements 4.5 hrs

3 Study guide—Part B: Statement of profit or loss and other 4 hrs

— Learning task: Statement of profit or loss and OCI 15 mins

4 Study guide—Part C: Statement of changes in equity 1 hr

5 Study guide—Part D: Statement of financial position 1 hr

6 Study guide—Part D: Statement of financial position 1.5 hrs

7 Study guide—Part E: IAS 7 Statement of Cash Flows 3 hrs

8 Study guide—Assumed knowledge review 15 mins

— Learning task: Statement of Cash Flows 1 hr

— Knowledge checks 30 mins

— Ask the expert forum: Module 2—Presentation of —

Total 21.5 hrs

1 Study guide—Part A: Revenue from contracts with 4.5 hrs

2 Study guide—Part A: Revenue from contracts 3 hrs

3 Study guide—Part A: Revenue from contracts with 2 hrs

4 Study guide—Part B: Provisions 3 hrs

5 Study guide—Part C: Contingent liabilities and 2 hrs

— Knowledge checks 24 mins

— Ask the expert forum: Module 3—Revenue from contracts —

1 Study guide—Part A: Income tax fundamentals 4.5 hrs

2 Study guide—Part A: Income tax fundamentals (continued) 4 hrs

3 Study guide—Part B: Recognition of deferred tax assets 2 hrs