P

ICAP
Advanced accounting and
financial reporting
Advanced accounting and financial reporting

Fifth edition published by

Emile Woolf International
Bracknell Enterprise & Innovation Hub
Ocean House, 12th Floor, The Ring
Bracknell, Berkshire, RG12 1AX
United Kingdom
Email: info@ewiglobal.com
www.emilewoolf.com

© Emile Woolf International, January 2022

All rights reserved. No part of this publication may be reproduced, stored in a retrieval system, or transmitted,
in any form or by any means, electronic, mechanical, photocopying, recording, scanning or otherwise, without
the prior permission in writing of Emile Woolf International, or as expressly permitted by law, or under the
terms agreed with the appropriate reprographics rights organisation.

You must not circulate this book in any other binding or cover and you must impose the same condition on
any acquirer.

Notice
Emile Woolf International has made every effort to ensure that at the time of writing the contents of this study
text are accurate, but neither Emile Woolf International nor its directors or employees shall be under any
liability whatsoever for any inaccurate or misleading information this work could contain.

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

 Certified Finance and Accounting Professional

C
Advanced accounting and financial reporting

Contents
Page

Chapter

1 Business combinations and consolidation 1

2 Business combinations achieved in stages 33

3 Consolidated statements of profit or loss and other comprehensive 49

income

4 Complex groups 59

5 Associates and joint ventures 85

6 Other group standards 97

7 IAS 21: Foreign currency 105

8 IAS 7: Statements of cash flows 131

9 IFRS 9: Financial instruments: Recognition and measurement 161

10 Financial instruments: Presentation and disclosure 203

11 IAS 19: Employee benefits 219

12 IFRS 2: Share based payments 239

13 Disposal of subsidiaries 279

14 IFRS 5: Non-current assets held for sale and discontinued operations 299

15 IFRS 13: Fair value measurement 315

© Emile Woolf International iii The Institute of Chartered Accountants of Pakistan

Advanced accounting and financial reporting

Page

16 IFRS 15: Revenue from contracts with customers 329

17 IFRS 16: Leases 351

18 IAS 12: Income taxes 391

19 Presentation of financial statements 429

20 IAS 36: Impairment of assets 439

21 Sundry standards 453

22 IFRS 1: First time adoption of IFRS 459

23 Specialised financial statements 467

24 International public sector accounting standards (IPSAS) 509

25 Accounting for hyperinflation 525

26 Islamic accounting standards 535

27 Professional ethics 545

© Emile Woolf International iv The Institute of Chartered Accountants of Pakistan

 Certified Finance and Accounting Professional

CHAPTER
Advanced accounting and financial reporting

Business combinations
and consolidation

Contents
1 The nature of a group and consolidated accounts
2 IFRS 10: Consolidated financial statements
3 IFRS 3: Business combinations
4 Consolidation technique
5 Accounting for goodwill
6 Disclosure

© Emile Woolf International 1 The Institute of Chartered Accountants of Pakistan

Advanced accounting and financial reporting

1 THE NATURE OF A GROUP AND CONSOLIDATED ACCOUNTS

Section overview

 International accounting standards and group accounts

 Relevant Standards
 The nature and purpose of consolidated financial statements

1.1 International accounting standards and group accounts

The following standards relate to accounting for investments:
 IFRS 3 Business combinations
 IFRS 10 Consolidated financial statements
 IFRS 11 Joint Arrangements
 IAS 27 Separate financial statements
 IAS 28 Investments in associates and joint ventures
IAS 1 and group accounts
IAS 1 requires that financial statements distinguish between:
 profit or loss for the period;
 other comprehensive income, which consists of gains or losses that are not reported in profit
or loss – such as gains on asset revaluations;
 transactions between the entity and its owners in their capacity as owners, which are called
‘equity transactions’ and reported in the statement of changes in equity.
This applies to consolidated accounts (group accounts).

1.2 Relevant Standards

IFRS 3 defines a business combination as a transaction or other event in which an acquirer obtains
control of one or more businesses.
IFRS 10 explains that a business under the control of another is a subsidiary and the controlling
entity is the parent.
IFRS 10 defines consolidated financial statements as the financial statements of a group in which
the assets, liabilities, equity, income, expenses and cash flows of the parent and its subsidiaries
are presented as those of a single economic entity. This means that groups must present their
financial statements in the form of consolidated accounts.
Guidance on the process of consolidation is set out in two standards, IFRS 3 Business
Combinations and IFRS 10 Consolidated Financial Statements.
IFRS 3 is largely about how the initial accounting for a new investment, setting out the rules on the
calculation of goodwill.
IFRS 10 covers the on-going rules related to consolidation. It is IFRS 10 that requires:
 that the financial statements of P and S be prepared using uniform accounting policies;
 the consolidated assets, liabilities, income and expenses are those of the parent and its
subsidiaries added on a line by line basis;
 the elimination of unrealised profit on intra group transactions; and
 the cancellation of intra group balances.

© Emile Woolf International 2 The Institute of Chartered Accountants of Pakistan

 Chapter 1: Business combinations and consolidation

Changes of ownership
IFRS 3 explains how to account for further investments in a subsidiary after control has been
achieved. These are called step acquisitions.
IFRS 10 explains how to account for disposals.

1.3 The nature and purpose of consolidated financial statements

A subsidiary is usually acquired through the purchase of a controlling interest in its equity. The
parent makes a long-term investment in the subsidiary. In the statement of financial position of the
parent, there is a non-current asset: ‘Investment in subsidiary, at cost’
Sometimes, a parent company has no assets at all except shares in the subsidiaries in the group.
A parent whose main assets (or only assets) are shares in subsidiaries is sometimes called a
holding company.
When a large part of the assets of a parent company consists of investments in subsidiaries, it is
difficult for the users of the financial statements of the parent to understand anything about its
financial position or financial performance. To find out meaningful information about their
investment, users of the parent’s financial statements need to know about the financial position
and performance of the operating subsidiaries.
The purpose of consolidated accounts is to provide financial statements that have meaning and
relevance to users.
When a parent acquires a subsidiary, both the parent and the subsidiary remain legally separate
entities. However, in practice they operate as if they were one organisation. Consolidated financial
statements reflect the reality (or substance) of the situation: the group is a single economic unit.
Consolidated financial statements are the financial statements of a group in which the assets,
liabilities, equity, income, expenses and cash flows of the parent and its subsidiaries are presented
as those of a single economic entity.

© Emile Woolf International 3 The Institute of Chartered Accountants of Pakistan

Advanced accounting and financial reporting

2 IFRS 10: CONSOLIDATED FINANCIAL STATEMENTS

Section overview

 Introduction to IFRS 10
 Situations where control exists
 The requirement to prepare consolidated accounts

2.1 Introduction to IFRS 10

IFRS 10 establishes principles for the presentation of consolidated financial statements when an
entity controls one or more other entities

Definitions: Group, parent and subsidiary

Group: A parent and its subsidiaries
Parent: An entity that controls one or more entities.
Subsidiary: An entity that is controlled by another entity.

A group consists of a parent entity and one or more entities that it has control over. These are
called subsidiaries.
The entity that ultimately controls all the entities in the group is called the parent.
Control
An entity is a subsidiary of another entity if it is controlled by that other entity.
IFRS 10 contains a principles based definition of control.

Definition: Control
An investor controls an investee when:
a. it is exposed, or has rights, to variable returns from its involvement with the investee; and
b. it has the ability to affect those returns through its power over the investee.

In other words, an investor controls an investee, if and only if, it has all the following:
 power over the investee;
 exposure, or rights, to variable returns from its involvement with the investee; and
 ability to use its power over the investee to affect the amount of its returns

2.2 Situations where control exists

The above definition of control is quite complicated.
In practice, the vast majority of cases involve a company achieving control of another through
buying a controlling interest in its shares.
Furthermore, in the vast majority of cases obtaining a controlling interest means buying shares
which give the holder more than 50% of the voting rights in the other company.

Illustration: Wholly owned subsidiary

A owns 100% of B’s voting share capital.
A
This 100% holding is described as a controlling interest and
100% gives A complete control of B.
B would be described as a wholly owned subsidiary.
B

© Emile Woolf International 4 The Institute of Chartered Accountants of Pakistan

 Chapter 1: Business combinations and consolidation

A company does not have to own all of the shares in another company in order to control it.
Illustration: Partly owned subsidiary
A owns 80% of B’s voting share capital.
A This 80% holding is described as a controlling interest and
80% gives A complete control of B.
B would be described as a partly owned subsidiary.
B
Other parties own the remaining 20% of the shares. They have
an ownership interest in B but do not have control.
This is described as a non-controlling interest.
Non-controlling interest (NCI) is defined by IFRS 10 as: “the
equity in a subsidiary not attributable to a parent.”

Control is assumed to exist when the parent owns directly, or indirectly through other subsidiaries,
more than half of the voting power of the entity, unless in exceptional circumstances it can be
clearly demonstrated that such control does not exist.

Illustration:

A
60% A owns a controlling interest in B.
B owns a controlling interest in C.
B
Therefore, A controls C indirectly through its ownership of B.
70% C is described as being a sub-subsidiary of A.
C

In certain circumstances, a company might control another company even if it owns shares which
give it less than half of the voting rights. Such a company is said to have de facto control over the
other company. (De facto is a Latin phrase which translates as of fact. It is used to mean in reality
or to refer to a position held in fact if not by legal right).

Illustration: Wholly owned subsidiary

A owns 45% of B’s voting share capital.
The other shares are held by a large number of unrelated investors none of whom individually own
more than 1% of B.
A This 45% holding probably gives A complete control of B.
45% It would be unlikely that a sufficient number of the other
shareholders would vote together to stop A directing the
B company as it wishes.

A company might control another company even if it owns shares which give it less than half of the
voting rights because it has an agreement with other shareholders which allow it to exercise control.

Illustration: Wholly owned subsidiary

A owns 45% of B’s voting share capital.
A further 10% is held by A’s bank who have agreed to use their vote as directed by A.

A
This 45% holding together with its power to use the votes
45% attached to the banks shares gives A complete control of B.
B

© Emile Woolf International 5 The Institute of Chartered Accountants of Pakistan

Advanced accounting and financial reporting

It was stated above but is worth emphasising that in the vast majority of cases control is achieved
through the purchase of shares that give the holder more than 50% of the voting rights in a
company.
Two or more investors collectively control an investee when they must act together to direct the
relevant activities. If this is the case, no investor can direct the activities without the co-operation
of the others so no investor individually controls the investee and it is not a subsidiary. Each
investor must account for its interest in accordance with the relevant IFRSs, such as IFRS 11 Joint
Arrangements, IAS 28 Investments in Associates and Joint Ventures or IFRS 9 Financial
Instruments.
Power
An investor has power over an investee when it has existing rights that give it the current ability to
direct the relevant activities (the activities that significantly affect the investee’s returns). This power
does not necessarily have to be exercised. As long as the rights exist, all other things being equal,
the investee is a subsidiary.
Power arises from rights.
 Assessing power is often straightforward – for example when power arises through holding
more than 50% of voting rights; or
 Assessing power might be more complex, for example:
 when power results from one or more contractual arrangements; or
 when power is due to a dominant but not majority shareholding.
Only substantive rights are taken into account. Substantive rights are rights that an investor has
the practical ability to exercise. Usually such rights must be currently exercisable so that the entity
is in a position to direct the relevant activities of the other entity. However sometimes rights might
be substantive, even though they are not currently exercisable.

Example: Substantive rights

S Ltd. is an investee company.
Policies over the relevant activities can be changed only at special or scheduled shareholders’
meetings. This includes the approval of material sales of assets as well as the making or disposing
of significant investments.
S Ltd. holds annual shareholder meetings at which decisions to direct the relevant activities are
made. The next scheduled shareholders’ meeting is in eight months.
Shareholders that individually or collectively hold at least 5% of the voting rights can call a special
meeting to change the existing policies over the relevant activities with 30 days’ notice.
X Ltd holds a majority of the voting rights in S Ltd. Are these rights substantive?

Answer
The rights are substantive and S Ltd is a subsidiary of X Ltd.
X Ltd is able to make decisions about the direction of the relevant activities when they need to be
made. The fact that it takes 30 days before it can exercise its voting rights does not stop it from
having the current ability to direct the relevant activities.

Example: Substantive rights

B Ltd is an investee company (with the same fact pattern as for S Ltd above).
A Ltd holds an option, which if exercised, would give it ownership of shares with more than 50% of
the voting rights of B Ltd. This option is exercisable in 25 days and is deeply in the money.
Is B Ltd a subsidiary of A Ltd?

© Emile Woolf International 6 The Institute of Chartered Accountants of Pakistan

 Chapter 1: Business combinations and consolidation

Answer
The option contract is a substantive right that gives A Ltd the current ability to direct the relevant
activities of B Ltd.
A Ltd has rights that are essentially equivalent to those of a majority shareholder in that it can
make decisions about the direction of the relevant activities when they need to be made.
The fact that it takes 30 days before it can exercise its votes does not stop it from having the current
ability to direct the relevant activities.
B Ltd is a subsidiary of A Ltd.

2.3 The requirement to prepare consolidated accounts

Definition
Consolidated financial statements: The financial statements of a group in which the assets,
liabilities, equity, income, expenses and cash flows of the parent and its subsidiaries are presented
as those of a single economic entity

All parents?
An entity that is a parent must present consolidated financial statements.
There is an exception to this rule. A parent need not present consolidated financial statements if
(and only if) it meets all of the following conditions:
 The parent itself (X) is a wholly-owned subsidiary, with its own parent (Y).
 Alternatively, the parent (X) is a partially-owned subsidiary, with its own parent (Y), and the
other owners of X are prepared to allow it to avoid preparing consolidated financial
statements.
 The parent’s debt or equity instruments are not traded in a public market.
 The parent does not file its financial statements with a securities commission for the purpose
of issuing financial instruments in a public market.
 The parent’s own parent, or the ultimate parent company (for example, the parent of the
parent’s parent), does produce consolidated financial statements for public use that comply
with International Financial Reporting Standards.
All subsidiaries?
Consolidated financial statements should include all the subsidiaries of the parent from the date at
which control is achieved to the date upon which control is lost.
A question might explain that a parent does not wish to consolidate a subsidiary but it would usually
have to do so. The following might be given as spurious justification for failing to consolidate a
particular subsidiary:
 The subsidiary’s activities are dissimilar from those of the parent, so that the consolidated
financial statements might not present the group’s financial performance and position fairly.
 Obtaining the information needed would be expensive and time-consuming and might delay
the preparation of the consolidated financial statements.
 The subsidiary operates under severe long term restrictions, so that the parent is unable to
manage it properly. For example, a subsidiary might be located in a country badly disrupted
by a war or a revolution. However, note that if the parent loses control then the investee is
no longer a subsidiary and should not be consolidated.
Sometimes a group is acquired and the new parent intends to sell one of the new subsidiaries. In
this case the subsidiary is accounted for as discontinued operation according to the rules in IFRS
 This means that all of its assets and all of its liabilities are included as separate lines on the
face of the statement of financial position and the group share of its profit (or loss) is shown
as a separate line on the face of the statement of profit or loss.

© Emile Woolf International 7 The Institute of Chartered Accountants of Pakistan

Advanced accounting and financial reporting

Investment entities exemption

Under normal rules a parent must consolidate all controlled entities.
A parent shall determine whether it is an investment entity. An investment entity is an entity that:
(a) obtains funds from one or more investors for the purpose of providing those investor(s) with
investment management services;
(b) commits to its investor(s) that its business purpose is to invest funds solely for returns from
capital appreciation, investment income, or both; and
(c) measures and evaluates the performance of substantially all of its investments on a fair value
basis.
In assessing whether it meets the definition described in above paragraph, an entity shall consider
whether it has the following typical characteristics of an investment entity:
(a) it has more than one investment;
(b) it has more than one investor;
(c) it has investors that are not related parties of the entity; and
(d) it has ownership interests in the form of equity or similar interests
However, an investment entity might take shares in another entity in order to make gains through
dividends or capital appreciation, not to become involved in business of that entity. Furthermore,
an investment entity might hold shares in a diverse range of businesses in very different sectors.
These requirements apply to an entity whose business activity is primarily investing activity for
example, venture capitalists, unit trusts and mutual funds. Some investments of such entities may
result in control.
An investment entity must not consolidate the entities that it controls but it must measure them at
fair value through profit or loss in accordance with IFRS 9 Financial Instruments.

© Emile Woolf International 8 The Institute of Chartered Accountants of Pakistan

 Chapter 1: Business combinations and consolidation

3 IFRS 3: BUSINESS COMBINATIONS

Section overview

 Introduction to IFRS 3
 Acquisition method
 Goodwill
 Cost (consideration transferred)
 Acquisition date amounts of assets acquired and liabilities assumed

3.1 Introduction to IFRS 3

Definitions
A business combination is a transaction or other event in which an acquirer obtains control of one
or more businesses.
A business is an integrated set of activities and assets that is capable of being conducted and
managed for the purpose of providing goods or services to customers, generating investment
income (e.g. dividends or interests) or generating other income from ordinary activities.

Objective of IFRS 3
The objective of IFRS 3 is to improve the relevance, reliability and comparability of information
reported about business combinations and their effects.
It establishes principles and requirements for:
 the recognition and measurement of identifiable assets acquired, liabilities assumed and
non-controlling interest in the acquiree;
 the recognition and measurement of goodwill (or a gain from a bargain purchase); and
 disclosures that enable users to evaluate the nature and financial effects of a business
combination.
Transactions under common control are not within the scope of IFRS 3. This means that transfers
of ownership of a subsidiary within a group (for example in group reconstructions) are not subject
to the rules in this standard. Companies engaging in such transactions must develop accounting
policies in accordance with the guidance given in IAS 8.

3.2 Acquisition method

All business combinations are accounted for by the acquisition method which involves:
 identifying the acquirer;
 determining the acquisition date;
 recognising and measuring the identifiable assets acquired, the liabilities assumed and any
non-controlling interest in the acquiree; and
 recognising and measuring goodwill or a gain from a bargain purchase
Identifying the acquirer
It might be difficult to identify an acquirer:
 The acquirer is usually the combining entity whose relative size is significantly greater than
that of the other(s).
 In a business combination affected by transferring cash (other assets) or by incurring
liabilities the acquirer is usually the entity that makes the transfer or incurs the liabilities.

© Emile Woolf International 9 The Institute of Chartered Accountants of Pakistan

Advanced accounting and financial reporting

 In a business combinations affected by exchange of equity interests the acquirer is usually

the entity that issues equity (however, in a “reverse acquisition” the issuing entity is the
acquiree).
Also note that the acquirer is usually the entity:
 whose owners have the largest portion of the voting rights in the combined entity;
 whose owners have the ability to determine the composition of the governing body of the
combined entity;
 whose (former) management dominates the management of the combined entity;
 that pays a premium over the pre-combination fair value of the equity interests of the others
Determining the acquisition date
Acquisition date is the date on which the acquirer effectively obtains control of the acquiree.
This generally the closing date (date of transfer of consideration and when net assets are acquired)
but might be before or after this date depending on circumstances.

3.3 Goodwill
IFRS 3 is largely about the calculation of goodwill.

Definition: Goodwill
Goodwill: An asset representing the future economic benefits arising from other assets acquired in
a business combination that are not individually identified and separately recognised.

IFRS 3 sets out the calculation of goodwill as follows:

Illustration: Goodwill
At the date of acquisition.
Rs.
Consideration transferred (cost of the business combination) X
Non-controlling interest X
X
The fair value of identifiable net assets (X)
Goodwill recognised X

The non-controlling interest may be stated as either:

 a proportionate share of the identifiable assets acquired and liabilities assumed; or
 at fair value as at the date of acquisition
Issues to address:
IFRS 3 gives guidance on:
 cost of a business combination;
 recognition and measurement of identifiable assets and liabilities assumed; and
 accounting for goodwill.

3.4 Cost (consideration transferred)

IFRS 3 states that the purchase consideration for an acquisition (business combination) is the sum
of:

© Emile Woolf International 10 The Institute of Chartered Accountants of Pakistan

 Chapter 1: Business combinations and consolidation

 the fair values, at the acquisition date, of the assets transferred by the acquirer, such as
cash
 the liabilities incurred by the acquirer to the former owners of the acquire
 equity instruments issued by the acquirer in exchange for control of the acquiree.
The purchase consideration may include some deferred consideration.
When the acquirer issues ordinary shares as part of the purchase consideration and the shares
are quoted equity instruments, they are normally valued at their market price at the acquisition date
for the purpose of measuring the consideration/acquisition cost.
If the consideration includes assets or liabilities of the acquirer that have carrying amounts that
differ from their fair values at the acquisition date (for example, non-monetary assets), these are
revalued with gains and losses taken to Profit or Loss.
Consideration includes any asset or liability resulting from a contingent consideration arrangement:
 recognised at acquisition-date fair value; and
 classified as a liability or equity on the basis of guidance in IAS 32 or other applicable IFRSs.
A right to the return of previously transferred consideration is classified as an asset if specified
conditions are met.
Costs of acquisition: transaction costs
Acquisition-related (transaction) costs are costs the acquirer incurs to effect a business
combination. For example, the cost of the advisory, legal, accounting, valuation or consultancy
fees, must not be included in the cost of the acquisition. These costs must be treated as an expense
as incurred and written off to profit or loss.
The amount of transaction costs associated with an acquisition and written off during the period to
profit or loss must be disclosed in a note to the financial statements.

Example: Cost of acquisition

Company P acquired 80% of the shares of Company S when the fair value of the net assets of S
was Rs. 800,000.
The purchase price was Rs. 300,000 in cash plus 10,000 new shares in Company P.
The new shares were to be issued 1 month after the date of acquisition.
The market value of P’s shares at the date of acquisition was Rs.40 each. One month later the
market value had increased to Rs.45.
The costs of making the acquisition were Rs. 80,000.
The cost of the investment in the shares of S = Rs. 300,000 + (10,000 × Rs.40 = Rs. 700,000. The
share price at the date of acquisition is used not that at the date of issue.
The costs of making the acquisition should be written off to profit or loss.
The parent company’s share of the net assets of S at the acquisition date was Rs. 640,000 (80% ×
Rs. 800,000). Purchased goodwill attributable to owners of the parent company is therefore Rs.
60,000 (Rs. 700,000 - Rs. 640,000).

Contingent consideration
Sometimes the final cost of the combination is contingent on (depends on) a future event. For
example, an acquirer could agree to pay an additional amount if the acquired subsidiary’s profits
exceed a certain level within three years of the acquisition.
In a situation such as this, the contingent payment should be included in the cost of the combination
(discounted to present value if the payment will occur more than 12 months in the future).
Under the rules of IFRS 3, contingent consideration must be recognised at fair value at acquisition,
even if it is not probable that the consideration will actually have to be paid.

© Emile Woolf International 11 The Institute of Chartered Accountants of Pakistan

Advanced accounting and financial reporting

Examples of potential forms of consideration include other assets, a business or a subsidiary of

the acquirer, ordinary or preference equity instruments, options and warrants

Example: Contingent consideration

Company X purchased 100% of the issued capital of Company S on 1 January Year 4.
The purchase agreement required Company X to pay Rs. 300,000 in cash immediately and an
additional sum of Rs. 100,000 on 31 December Year 6 if the earnings of Company S increase at
an annual rate of 25% per year in each of the three years following the acquisition.
How should the contingent payment be recognised in calculating the goodwill arising at the date of
acquisition?

Answer
The contingent consideration should be included in the cost of investment (the purchase
consideration) whether or not it is probable that it will have to be paid. The contingent consideration
of Rs. 100,000 should be measured at fair value.
If it is fairly certain that the contingent consideration will have to be paid, an appropriate measure
of fair value might be the present value of the future payment, discounted at an appropriate cost
of capital. The purchase consideration is therefore Rs. 300,000 plus the present value of the
contingent (deferred) consideration.

If there is still contingent consideration at the end of an accounting period, it might be necessary
to re-measure it.
If the contingent consideration will be payable in cash, it should be re-measured to fair value at the
end of the reporting period. Any gain or loss on re-measurement should be taken to profit or loss.
If the contingent consideration will take the form of debt, the amount of the debt is re-measured at
fair value at the end of the reporting period and the change in value is recognised in profit or loss
in the period.
If the contingent consideration will take the form of equity, it is not re-measured at the end of the
reporting period. The eventual settlement of the payment will be accounted for as an equity
transaction (i.e. a transaction between the entity and owners of the group in their capacity as
owners).
A reason for re-measuring the contingent consideration is that the amount payable might depend
on the performance of the subsidiary after its acquisition.
If the profits are higher than expected, the contingent consideration might be re-measured to a
higher value, increasing the liability (the contingent payment) and reducing the reported profit for
the period.
Similarly, if the profits are lower than expected, the contingent consideration might be re-measured
to a lower value, reducing the liability (the contingent payment) and increasing the reported profit
for the period.
Share options given to the previous owners
When an entity acquires a subsidiary that was previously managed by its owners, the previous
owners might be given share options in the entity as an incentive to stay on and work for the
subsidiary after it has been acquired. IFRS 3 states that the award of share options in these
circumstances is not a part of the purchase consideration. The options are post-acquisition
employment expenses and should be accounted for as share-based payments in accordance with
IFRS 2.
3.5 Acquisition date amounts of assets acquired and liabilities assumed
Core principle
An acquirer of a business must recognise assets acquired and liabilities assumed at their
acquisition date fair values and disclose information that enables users to evaluate the nature and
financial effects of the acquisition.

© Emile Woolf International 12 The Institute of Chartered Accountants of Pakistan

 Chapter 1: Business combinations and consolidation

To support this IFRS 3 sets out:

 a recognition principle;
 classification guidance; with
 a measurement principle.
There are specified exceptions to each of these.
Any asset acquired or liability assumed is subsequently measured in accordance with applicable
IFRS. There are also exceptions to this rule.
Recognition principle
An acquirer must recognise (separately from goodwill), identifiable assets acquired, liabilities
assumed and any non-controlling interest in the acquiree as of the acquisition date.
To qualify for recognition identifiable assets acquired and liabilities assumed must meet the
definitions of assets and liabilities set out in The Conceptual Framework as at the acquisition date.
This might result in recognition of assets and liabilities not previously recognised by the acquiree.
When a company acquires a subsidiary, it may identify intangible assets of the acquired subsidiary,
which are not included in the subsidiary’s statement of financial position. If these assets are
separately identifiable and can be measured reliably, they should be included in the consolidated
statement of financial position as intangible assets, and accounted for as such.
This can result in the recognition of assets and liabilities not previously recognised by the acquiree.

Illustration: Identifiable asset on acquisition

If a company bought 100% of the Coca-Cola Corporation they would be buying a lot of assets but
part (perhaps the largest part) of the purchase consideration would be to buy the Coca Cola brand.
Coca Cola does not recognise its own brand in its own financial statements because companies
are not allowed to recognised internally generated brands.
However, as far as the company buying the Coca-Cola Corporation is concerned the brand is a
purchased asset. It would be recognised in the consolidated financial statements and would be
taken into account in the goodwill calculation.
Contingent liabilities
Many acquired businesses will contain contingent liabilities such as contingent liabilities for the
settlement of legal disputes or for warranty liabilities. IFRS 3 states that contingent liabilities should
be recognised at acquisition ‘even if it is not probable that an outflow of resources embodying
economic benefits will be required to settle the obligation.’
The contingent liabilities should be measure Measurement principle
Identifiable assets acquired and the liabilities assumed are measured at their acquisition date fair
values.

Definition: Fair value

Fair value: The price that would be received to sell an asset or paid to transfer a liability in an orderly
transaction between market participants at the measurement date.

The net assets of a newly acquired business are subject to a fair valuation exercise.
The table below shows how different types of asset and liability should be valued.

Item Fair value

Marketable investments Current market value
Non-marketable Estimated values that take into consideration features such as:
investments (a) price earnings ratios
(b) dividend yield
(c) expected growth rates of comparable investments

© Emile Woolf International 13 The Institute of Chartered Accountants of Pakistan

Advanced accounting and financial reporting

Item Fair value

Trade and other Present values of the amounts to be received. This is normally the
receivables same as the book value. Discounting is not usually required because
amounts are expected to be received within a few months.
Inventories: finished Selling price less the sum of:
goods (a) the costs of disposal, and
(b) a reasonable profit allowance for the selling effort of the
acquirer based on profit for similar finished goods.
Inventories: work in Selling price of finished goods less the sum of:
progress (a) costs to complete,
(b) costs of disposal, and
(c) a reasonable profit for the completing and selling effort based
on profit for similar finished goods.
Inventories: raw Current replacement costs
materials
Land and buildings Market value
Plant and equipment Normally market value. Use depreciated replacement cost if market
value cannot be used (e.g., because of the specialised nature of the
plant and equipment or because the items are rarely sold, except as
part of a continuing business).
Intangible assets As discussed above
Trade and other Present values of amounts to be disbursed in meeting the liability
payables; long-term debt determined at appropriate current interest rates. For current liabilities
and other liabilities. this is normally the same as book value.

Exception to the recognition principle

Topic Recognition Measurement at Measurement at later

principle acquisition dates
Contingent liability Defined by IAS 37 Fair value At the higher of the original
and not recognised. amount and the amount
Contingent liability that would be reported
due to a present under IAS 37.
obligation is
recognised
Exceptions to both the recognition and measurement principles
Income taxes IAS 12 applies IAS 12 applies IAS 12 applies
Employee benefits IAS 19 applies IAS 19 applies IAS 19 applies
Indemnification This is a right to be Measurement of Measurement of the asset
assets compensated by the asset mirrors mirrors the recognition of
the seller if a the recognition of the liability
defined the liability
contingency occurs
Recognition of the
asset mirrors the
recognition of the
liability
Leases in which the IFRS 16 applies IFRS 16 applies IFRS 16 applies
acquiree is the
lessee

© Emile Woolf International 14 The Institute of Chartered Accountants of Pakistan

 Chapter 1: Business combinations and consolidation

Topic Recognition Measurement at Measurement at later

principle acquisition dates
Exceptions to the measurement principle
Reacquired rights N/A Recognised as an The asset recognised is
intangible asset amortised over the
and measured on remaining contractual
the basis of the period of the contract in
remaining which the right was
contractual term of granted.
the related contract
regardless of
whether market
participants would
consider potential
contractual
renewals in
determining its fair
value
Share based N/A IFRS 2 applies
payments
Assets held for sale N/A IFRS 5 applies

Deferred tax
Deferred income tax assets and liabilities are recognised and measured in accordance with IAS
12 Income Taxes, rather than at their acquisition-date fair values.
Measurement period
Initial accounting for goodwill may be determined on a provisional basis and must be finalised by
the end of a measurement period.
This ends as soon as the acquirer receives the information it was seeking about facts and
circumstances that existed at the acquisition date but must not exceed one year from the
acquisition date.
During the measurement period new information obtained about facts and circumstances that
existed at the acquisition date might lead to the adjustment of provisional amounts or recognition
of additional assets or liabilities with a corresponding change to goodwill.
Any adjustment restates the figures as if the accounting for the business combination had been
completed at the acquisition date.
Classification guidance
Identifiable assets acquired and liabilities assumed must be classified (designated) as necessary
at the acquisition date so as to allow subsequent application of appropriate IFRS.
The classification is based on relevant circumstances as at the acquisition date with two
exceptions:
 classification of a lease contract in accordance with IFRS 16 Leases; and
 classification of a contract as an insurance contract in accordance with IFRS 4 Insurance
Contracts.
Classification in these cases is based on circumstances at the inception of the contract or date of
a later modification that would change the classification.

© Emile Woolf International 15 The Institute of Chartered Accountants of Pakistan

Advanced accounting and financial reporting

4 CONSOLIDATION TECHNIQUE
Section overview

 The basic approach

 Practice questions

4.1 The basic approach

Suggested step by step approach to the preparation of consolidated statements of financial position
To prepare a consolidated statement of financial position as at the acquisition date, the following
steps should be taken.
Step 1: Establish the group share (parent company share) in the subsidiary and the percentage
owned by non-controlling interests.
Step 2: Perform double entry to record any individual company adjustments that might be
necessary. Mark these in the face of the question. The information can be lifted into workings later
so that the marker can understand what you have done.
Step 3: Set out a pro-for ma (skeleton) statement of financial position and fill in the easy
numbers (for example those assets and liabilities that are a straight cross cast and the share
capital)
Step 4: Calculate the net assets of the subsidiary at the acquisition date and at the end of the
reporting period taking into account information about the fair value of assets at the acquisition
date and the existence of any assets not recognised by the subsidiary that might need to be
capitalised for consolidation purposes.
Step 5: Calculate the goodwill

Illustration: Goodwill

Rs.
Consideration transferred (cost of the business combination) X
Non-controlling interest X
X
The net of the acquisition date amounts of identifiable assets
acquired and liabilities assumed (measured in accordance with
IFRS 3) (X)
Goodwill recognised X

Step 6: Calculate the non-controlling interest.

Illustration: Consolidated retained earnings

Rs.
NCI at the date of acquisition X
NCI’s share of the post-acquisition retained earnings of S X
NCI’s share of each other post-acquisition reserves of S (if any) X
NCI at the date of consolidation X

Step 7: Calculate consolidated retained earnings.

© Emile Woolf International 16 The Institute of Chartered Accountants of Pakistan

 Chapter 1: Business combinations and consolidation

Possible complications
You should be familiar with the following of possible complications that you may need to take into
account when answering questions:
 Before consolidation
 Measuring the cost of acquisition
 Identifying assets not recognised by the subsidiary which need to be included for
consolidation purposes
 Performing the fair value exercise
Construct a net assets summary of each subsidiary showing net assets at the date of acquisition
and at the reporting date.
 During consolidation
 Mid-year acquisition – consolidation must be from the date of acquisition so you may
need to construct a net assets total for a subsidiary at a point during the previous year.
 Elimination of inter-company balances
 Elimination of unrealised profit.
 After consolidation
 Impairment testing goodwill or
 Accounting for a gain on a bargain purchase.

4.2 Practice questions

Practice question 1
P acquired 70% of S on 1 January 20X1 for Rs.450,000
The retained earnings of S were Rs. 50,000 at that date.
It is P’s policy to recognise non-controlling interest at the date of acquisition as a proportionate
share of net assets.
The statements of financial position P and S as at 31 December 20X1 were as follows:

Assets: P (Rs.) S(Rs.)

Investment in S, at cost 450,000 -
Other assets 500,000 350,000
950,000 350,000
Equity
Share capital 100,000 100,000
Retained earnings 650,000 100,000
750,000 200,000
Current liabilities 200,000 150,000
950,000 350,000

Required
Prepare a consolidated statement of financial position as at 31 December
20X1.

© Emile Woolf International 17 The Institute of Chartered Accountants of Pakistan

Advanced accounting and financial reporting

Practice question 2
P acquired 70% of S on 1 January 20X1 for Rs.450,000
The retained earnings of S were Rs. 50,000 at that date.
It is P’s policy to recognise non-controlling interest at the date of acquisition at fair value.
The fair value of the non-controlling interest at the date of acquisition was Rs. 75,000.
The statements of financial position P and S as at 31 December 20X1 were as follows:
Assets: P (Rs.) S(Rs.)
Investment in S, at cost 450,000 -
Other assets 500,000 350,000
950,000 350,000
Equity
Share capital 100,000 100,000
Retained earnings 650,000 100,000
750,000 200,000
Current liabilities 200,000 150,000
950,000 350,000

Required
Prepare a consolidated statement of financial position as at 31 December
20X1.

Practice question 3
P bought 80% of S 2 years ago.
At the date of acquisition S’s retained earnings stood at Rs. 600,000. The fair value of its
net assets was not materially different from the book value except for the fact that it had a
brand which was not recognised in S’s accounts. This had a fair value of 100,000 at this
date and an estimated useful life of 20 years.
The statements of financial position P and S as at 31 December 20X1 were as follows:
P (Rs.) S(Rs.)
PP and E 1,800,000 1,000,000
Investment in S 1,000,000
Other assets 400,000 300,000
3,200,000 1,300,000

Share capital 100,000 100,000

Retained earnings 2,900,000 1,000,000
Liabilities 200,000 200,000
3,200,000 1,300,000

Required
Prepare a consolidated statement of financial position as at 31 December
20X1.

© Emile Woolf International 18 The Institute of Chartered Accountants of Pakistan

 Chapter 1: Business combinations and consolidation

Practice question 4
P bought 80% of S 2 years ago.
At the date of acquisition S’s retained earnings stood at Rs. 600,000 and the fair value of its
net assets were Rs. 1,000,000. This was Rs. 300,000 above the book value of the net assets
at this date.
The revaluation was due to an asset that had a remaining useful economic life of 10 years
as at the date of acquisition.
The statements of financial position P and S as at 31 December 20X1 were as follows:
P S
Rs. Rs.
PP and E 1,800,000 1,000,000
Investment in S 1,000,000
Other assets 400,000 300,000
3,200,000 1,300,000

Share capital 100,000 100,000

Retained earnings 2,900,000 1,000,000
Liabilities 200,000 200,000
3,200,000 1,300,000
Required
Prepare a consolidated statement of financial position as at 31 December 20X1.

Practice question 5
P acquired 70% of S on 1 January 20X1 for Rs.1,000,000
The retained earnings of S were Rs. 50,000 at that date.
Also, at the date of acquisition S held an item of plant with a carrying amount of 250,000
less than its fair value. This asset had a remaining useful life of 10 years as from that date.
It is P’s policy to recognise non-controlling interest at the date of acquisition as a
proportionate share of net assets.
The statements of financial position of P and S as at 31 December 20X1 were as follows:
P (Rs.) S(Rs.)
Assets:
Investment in S, at cost 1,000,000 -
Other non-current assets 400,000 200,000
Current assets 500,000 350,000
1,900,000 550,000
Equity
Share capital 100,000 100,000
Retained earnings 1,600,000 300,000
1,700,000 400,000
Current liabilities 200,000 150,000
1,900,000 550,000
Required
Prepare a consolidated statement of financial position as at 31 December 20X1.

© Emile Woolf International 19 The Institute of Chartered Accountants of Pakistan

Advanced accounting and financial reporting

5 ACCOUNTING FOR GOODWILL

Section overview

 Accounting for goodwill

 Impairment testing of goodwill

5.1 Accounting for goodwill

Positive goodwill - Excess of cost of combination over share of net assets
After initial recognition goodwill is measured at cost less any accumulated impairment losses.
 Goodwill acquired in a business combination is not amortised.
 It is tested for impairment annually or more frequently if events or changes in circumstances
indicate that it might be impaired, in accordance with IAS 36, Impairment of Assets.
Gain from a bargain purchase (“Negative goodwill”)
A bargain purchase is a business combination in which the calculation of goodwill leads to a
negative figure.
When this happens the acquirer must reassess whether it has correctly identified all of the assets
acquired and all of the liabilities assumed and must recognise any additional assets or liabilities
that are identified in that review.
The acquirer must then review the procedures used to measure the amounts this IFRS requires to
be recognised at the acquisition date for all of the following:
 the identifiable assets acquired and liabilities assumed;
 the non-controlling interest in the acquiree (if any); and
 the consideration transferred.
Any amount remaining after applying the above requirements is recognised as a gain in profit or
loss on the acquisition date.
This means that in most cases when a bargain purchase occurs, the ‘negative goodwill’ should be
added to the consolidated profit for the group for the year.

5.2 Impairment testing of goodwill

Purchased goodwill is not amortised, but must be tested for impairment on an annual basis. It
cannot be tested for impairment directly. It is allocated to one or more cash generating unit (IAS
36) and then the carrying amount of the cash generating unit is compared to its recoverable
amount.
The following discussion and examples assume that the subsidiary in question is a cash generating
unit (CGU).
Partial goodwill method (NCI at acquisition measured as a proportionate share of subsidiary’s net
assets
Recoverable amount of the CGU is based on the cash flows that its assets are expected to
generate (either through use or sale of the unit). These cash flows will be a function of all of the
assets of the unit including the NCI’s share of the goodwill but this latter figure has not been
recognised.
The carrying amount of the CGU is made up of:
 the total net assets of the unit (parent’s interest and NCI’s); and
 the parent’s interest in goodwill.

© Emile Woolf International 20 The Institute of Chartered Accountants of Pakistan

 Chapter 1: Business combinations and consolidation

Any comparison of carrying amount to recoverable amount should compare like to like except
goodwill. The goodwill included in the CGU, as stated above, represents the parent’s share only,
but the cash flow contributed by goodwill does not pertain to parent share of goodwill only. It also
includes contribution made by NCI share of goodwill. Therefore, IAS 36 requires a working that
grosses up the carrying amount of the CGU’s assets by the NCI share of goodwill. Note that this
is only in a working; it is not part of the double entry.
This notionally adjusted carrying amount is then compared with the recoverable amount of the unit
to determine whether the cash-generating unit is impaired.
Any impairment is charged against the goodwill in the first instance with any balance writing down
other assets in the unit.
Only that part of any impairment loss attributable to the parent is recognised by the entity as a
goodwill impairment loss.

Example: Impairment of goodwill

X Ltd paid Rs. 1,600 for an 80% interest in Y Ltd on 01/01/X1.
On this date Y had identifiable net assets with a fair value of Rs. 1,500.
Goodwill on acquisition: Rs.
Cost of acquisition 1,600
Share of net assets (80%  Rs.1,500) (1,200)
Goodwill 400
The following amounts are recognised in the consolidated financial statements at the date of
acquisition:
Rs.
Goodwill 400
Asset 1,500
NCI (20%  1,500) 300
This cash-generating unit includes goodwill within its carrying amount, so it must be tested for
impairment annually (or more frequently if there is an indication that it may be impaired).
31/12/X1 – Impairment test
X Ltd estimates that the recoverable amount of Y Ltd is Rs. 1,400.
The net assets of Y Ltd (after fair value adjustments) were still Rs. 1,520.
Carrying amount of Y Ltd: Goodwill Asset Total
As at 01/01/X1 400 1,500 1,900
Notional grossing up of goodwill
400  20/80 100 - 100
500 1,500 2,000
Recoverable amount (1,520)
Impairment loss 480

The whole loss (480) is covered by the goodwill of 500 but only 80% of this is in the
financial statements. Therefore only 80% of the loss is recognised

Allocation of impairment loss Notional X Ltd X Ltd write

write off share off
Goodwill (notional) 480 80% 384

© Emile Woolf International 21 The Institute of Chartered Accountants of Pakistan

Advanced accounting and financial reporting

Example: Impairment of goodwill (continued)

Allocation of impairment loss Goodwill Asset Total
As at 31/12/X1 400 1,500 1,900
Impairment loss (384) (384)
16 1,500 1,516

Full goodwill method (NCI at acquisition measured at fair value

This is more straightforward.
If there is a NCI in a cash-generating unit to which goodwill has been allocated, the carrying amount
of that unit is made up of:
 both the parent’s interest and the NCI in the net assets of the unit; and
 both the parent’s interest in goodwill and the NCI’s interest in goodwill.
When non-controlling interests are valued by the fair value method, any impairment in the total
goodwill after acquisition should be shared between the parent company shareholders and the
NCI.
It is tempting to allocate the write off of goodwill between the parent and NCI in proportion to the
goodwill attributable to each. However, para C6, Appendix C to IAS 36 says that the impairment
should be “allocated between the parent and the NCI on the same basis as that on which profit or
loss is allocated”.

Example: Impairment of goodwill

S has 10 million shares of Rs.1 each in issue. H acquired 80% of these shares at a price of Rs.11.6
million when the net assets of S were Rs.10 million. Prior to the acquisition, the shares of S had
been trading in the stock market at Rs.1.20 per share.
Suppose that subsequently goodwill is impaired in value by Rs.1.5 million, so that it is now valued
at just Rs. 2,500,000.
The impairment in the goodwill must be attributed to the parent company and the NCI in the
according to the proportions used to allocate profit or loss (80:20).
Goodwill
Total Parent NCI
Rs.000 Rs.000 Rs.000
Purchase consideration 11,600 11,600
Non-controlling interest
(2m shares @ Rs.1.2) 2,400 2,400
14,000
Fair value of net assets of subsidiary at
acquisition (10,000) (8,000) (2,000)
Goodwill 4,000 3,600 400
Impairment of goodwill: (1,500) (1,200) (300)
2,500 2,400 100
Note that the impairment is allocated 80:20 not 3,600:400 which might have been expected.

© Emile Woolf International 22 The Institute of Chartered Accountants of Pakistan

 Chapter 1: Business combinations and consolidation

6 DISCLOSURES
6.1 Disclosures
IFRS 3
The acquirer shall disclose information that enables users of its financial statements to evaluate
the nature and financial effect of a business combination that occurs either:
(a) during the current reporting period; or
(b) after the end of the reporting period but before the financial statements are authorised for issue.
The acquirer shall disclose information that enables users of its financial statements to evaluate
the financial effects of adjustments recognised in the current reporting period that relate to business
combinations that occurred in the period or previous reporting periods.
If the specific disclosures required by IFRS 3 and other IFRSs do not meet the objectives set out
in preceding paragraphs, the acquirer shall disclose whatever additional information is necessary
to meet those objectives.

© Emile Woolf International 23 The Institute of Chartered Accountants of Pakistan

Advanced accounting and financial reporting

SOLUTIONS TO PRACTICE QUESTIONS

Solution 1
P Group: Consolidated statement of financial position at 31 December 20X1
Assets Rs.
Goodwill (W3) 345,000
Other assets (500 + 350) 850,000
Total assets 1,195,000
Equity
Share capital (P only) 100,000
Consolidated retained earnings (W4) 685,000
785,000
Non-controlling interest (W2) 60,000
845,000
Current liabilities (200 + 150) 350,000
Total equity and liabilities 1,195,000

Workings:
W1 Net assets summary
At date of At date of Post-
consolidation acquisition acquisition
Share capital 100,000 100,000
Retained earnings 100,000 50,000 50,000
Net assets 200,000* 150,000

W2 Non-controlling interest Rs.

NCI’s share of net assets at the date of acquisition
(30%  150,000 (W1)) 45,000
NCI’s share of the post-acquisition retained earnings of S (30% of 50,000
(W1)) 15,000
NCI’s share of net assets at the date of consolidation 60,000
Alternative working
NCI’s share of net assets at the date of consolidation
(30%  200,000*) 60,000

© Emile Woolf International 24 The Institute of Chartered Accountants of Pakistan

 Chapter 1: Business combinations and consolidation

W3 Goodwill Rs.
Cost of investment 450,000
Non-controlling interest at acquisition (see W2) 45,000
495,000
Net assets at acquisition (W1) (150,000)
345,000

W4 Consolidated retained profits:

All of P’s retained earnings 650,000
P’s share of the post-acquisition retained earnings of S (70% of 50,000
(W1)) 35,000
685,000

Solution 2
P Group: Consolidated statement of financial position at 31 December 20X1

Assets Rs.

Goodwill (W3) 375,000

Other assets (500 + 350) 850,000

Total assets 1,225,000

Equity

Share capital (P only) 100,000

Consolidated retained earnings (W4) 685,000

785,000

Non-controlling interest (W2) 90,000

875,000

Current liabilities (200 + 150) 350,000

Total equity and liabilities 1,225,000

© Emile Woolf International 25 The Institute of Chartered Accountants of Pakistan

Advanced accounting and financial reporting

Workings:

W1 Net assets summary

At date of At date of Post-

consolidation acquisition acquisition

Share capital 100,000 100,000

Retained earnings 100,000 50,000 50,000

Net assets 200,000* 150,000

W2 Non-controlling interest Rs.

Fair value of NCI at the date of acquisition 75,000

NCI’s share of the post-acquisition retained earnings of S (30% of

50,000 (W1)) 15,000

NCI’s share of net assets at the date of consolidation 90,000

W3 Goodwill

Cost of investment 450,000

Non-controlling interest at acquisition (given) 75,000

525,000

Net assets at acquisition (W1) (150,000)

375,000

W4 Consolidated retained profits:

All of P’s retained earnings 650,000

P’s share of the post-acquisition retained earnings of S (70% of

50,000 (W1)) 35,000

685,000

© Emile Woolf International 26 The Institute of Chartered Accountants of Pakistan

 Chapter 1: Business combinations and consolidation

Solution 3
A consolidated statement of financial position as at 31 December 20X1 can be prepared as follows:

P Group: Consolidated statement of financial position at 31 December 20X1

Assets Rs.

Brand (see working) 90,000

Goodwill (see working) 360,000

Property, plant and equipment (1,800 + 1000) 2,800,000

Other assets (400 + 300) 700,000

Total assets 3,950,000

Equity

Share capital (P only) 100,000

Consolidated retained earnings (see working) 3,212,000

3,312,000

Non-controlling interest 238,000

3,550,000

Current liabilities (200 + 200) 400,000

Total equity and liabilities 3,950,000

Workings:
Net assets summary of S

At date of At date of Post-

consolidation acquisition acquisition

Share capital 100,000 100,000

Retained earnings

Given in the question 1,000,000 600,000

Extra depreciation on brand

(100,000 × 2 years/20 years) (10,000) 

990,000 600,000 390,000

Consolidation reserve on
recognition of the brand 100,000 100,000

Net assets 1,190,000 800,000

© Emile Woolf International 27 The Institute of Chartered Accountants of Pakistan

Advanced accounting and financial reporting

Non-controlling interest Rs.

NCI’s share of net assets at the date of acquisition

(20%  800,000) 160,000

NCI’s share of the post-acquisition retained earnings of S (20% of

390,000 (see above)) 78,000

NCI’s share of net assets at the date of consolidation 238,000

Goodwill

Cost of investment 1,000,000

Non-controlling interest at acquisition (20%  800,000) 160,000

1,160,000

Net assets at acquisition (see above) (800,000)

360,000

Consolidated retained profits:

All of P’s retained earnings 2,900,000

P’s share of the post-acquisition retained earnings of S (80% of

390,000 (see above)) 312,000

3,212,000

Brand

On initial recognition 100,000

Depreciation since acquisition (100,000 × 2 years/20 years) (10,000)

90,000

© Emile Woolf International 28 The Institute of Chartered Accountants of Pakistan

 Chapter 1: Business combinations and consolidation

Solution 4
P Group: Consolidated statement of financial position at 31 December 20X1

Assets Rs.

Goodwill (see working) 200,000

PP and E (see working) 3,040,000

Other assets (400,000 + 300,000) 700,000

Total assets 3,940,000

Equity

Share capital (P only) 100,000

Consolidated retained earnings (see working) 3,172,000

3,272,000

Non-controlling interest 268,000

3,540,000

Current liabilities (200 + 200) 400,000

Total equity and liabilities 3,940,000

At date of At date of Post-

consolidation acquisition acquisition

Share capital 100,000 100,000

Retained earnings

Given in the question 1,000,000 600,000

Extra depreciation on fair

value adjustment (300 × 2
years/10 years) – see explanation

on next page (60,000) 

940,000 600,000 340,000

Fair value reserve 300,000 300,000

Net assets 1,340,000 1,000,000

Non-controlling interest Rs.

NCI’s share of net assets at the date of acquisition

(20%  1,000) 200,000

NCI’s share of the post-acquisition retained earnings of S (20% of

340 (see above)) 68,000

NCI’s share of net assets at the date of consolidation 268,000

© Emile Woolf International 29 The Institute of Chartered Accountants of Pakistan

Advanced accounting and financial reporting

Goodwill Rs.

Cost of investment 1,000,000

Non-controlling interest at acquisition (20%  1,000) 200,000

1,200,000

Net assets at acquisition (see above) (1,000,000)

200,000

Consolidated retained profits:

All of P’s retained earnings 2,900,000

P’s share of the post-acquisition retained earnings of S (80% of

340 (see above)) 272,000

3,172,000

Property plant and equipment

Parent’s 1,800

Subsidiary’s

Given in question 1,000

Fair value adjustment 300

Extra depreciation on fair value adjustment

(300 × 2 years/10 years) (60)

1,240

To statement of financial position 3,040

Solution 5
P Group: Consolidated statement of financial position at 31 December 20X1

Assets Rs.

Goodwill (W3) 720,000

Other non-current assets (400 + (200 + 250  25)) 825,000

Other assets (500 + 350) 850,000

Total assets 2,395,000

© Emile Woolf International 30 The Institute of Chartered Accountants of Pakistan

 Chapter 1: Business combinations and consolidation

Equity Rs.

Share capital (P only) 100,000

Consolidated retained earnings (W4) 1,757,500

1,857,500

Non-controlling interest (W2) 187,500

2,045,000

Current liabilities (200 + 150) 350,000

Total equity and liabilities 2,395,000

Workings:

W1 Net assets summary

At date of At date of Post-

consolidation acquisition acquisition

Share capital 100,000 100,000

Retained earnings

Given in the question 300,000 50,000

Extra depreciation on fair value

adjustment (250 × 1 years/10 years) (25,000) 
275,000 50,000 225,000

Fair value reserve 250,000 250,000

Net assets 625,000 400,000

W2 Non-controlling interest Rs.

NCI’s share of net assets at the date of acquisition

(30%  400) 120,000

NCI’s share of the post-acquisition retained earnings of S (30% of

225 (W1)) 67,500

NCI’s share of net assets at the date of consolidation 187,500

W3 Goodwill

Cost of investment 1,000,000

Non-controlling interest at acquisition (W2) 120,000

1,120,000

Net assets at acquisition (see above) (400,000)

720,000

© Emile Woolf International 31 The Institute of Chartered Accountants of Pakistan

Advanced accounting and financial reporting

W4 Consolidated retained profits: Rs.

All of P’s retained earnings 1,600,000

P’s share of the post-acquisition retained earnings of S (70% of

225 (W1)) 157,500

1,757,500

© Emile Woolf International 32 The Institute of Chartered Accountants of Pakistan

 Certified Finance and Accounting Professional

CHAPTER
Advanced accounting and financial reporting

Business combinations
achieved in stages

Contents
1 Acquisitions achieved in stages
2 Pattern of ownership in the consolidated statement of profit
or loss

© Emile Woolf International 33 The Institute of Chartered Accountants of Pakistan

Advanced accounting and financial reporting

1 ACQUISITIONS ACHIEVED IN STAGES

Section overview

 Acquisitions achieved in stages

 Purchase of additional equity interest after control is achieved

1.1 Acquisitions achieved in stages

Control may be achieved in a single transaction as well as it might be achieved through a series of
transactions. (These transactions are known as step acquisitions, successive share purchases or
piecemeal acquisitions).
If the ownership is more than 50 %, the presumed influence is control and the accounting method
for initial recognition will be business combination under IFRS 3. The subsequent accounting will
be consolidation under IFRS 10.
Prior to control being achieved, an acquirer accounts for its investment in the equity interests of an
acquiree in accordance with the nature of the investment by applying the relevant standards i-e.
a) IAS 28: Investment in Associates and Joint Ventures; or
b) IFRS 9: Financial Instruments; or
c) IFRS 11: Joint Arrangements

Example: Step acquisition

A company may purchase a 35% stake, and then a year later, purchase a further 40%.
When the second purchase is made the company’s interest in the subsidiary increases from 35%
to 75%.
This is a controlling interest. IFRS refers to such a transaction as a business combination achieved
in stages, sometimes also referred to as a step acquisition
In other words, control is achieved at the date of the second acquisition.
This is the date of acquisition.

Consolidation is from the acquisition date which is the date on which control is achieved. Goodwill
is calculated at the acquisition date with reference to the fair value of the consideration.
IFRS 3 requires that, for a business combination achieved in stages, the parent must remeasure
any previously held equity interest in the new subsidiary to its fair value at the date that control is
achieved. This is added to the cost of the investment that resulted in control. This figure is used to
calculate goodwill.
Goodwill is measured as follows:
Illustration: Goodwill
Rs.
Consideration transferred (cost of the business combination) X
The acquisition-date fair value of the acquirer’s previously held
equity interest in the entity X
Non-controlling interest X
X
The net of the acquisition date amounts of identifiable assets
acquired and liabilities assumed (X)
Goodwill recognised X

The resulting gain or loss on the remeasurement of the previously held equity interest is recognised
in profit or loss or other comprehensive income, as appropriate.

© Emile Woolf International 34 The Institute of Chartered Accountants of Pakistan

 Chapter 2: Business combinations achieved in stages

Example: Step acquisition

H bought 10% of S 2 years ago for Rs. 45m. The balance on S’s retained earnings was Rs. 150m
at this date.
H bought 60% of S 1 year ago for Rs. 540m. The balance on S’s retained earnings was Rs. 300m
at this date and S held a non-current asset with a fair value of Rs. 150m more than its carrying
amount.
The fair value of the original investment (10%) in S was Rs. 60m at this date.
Statements of financial position for H and S as at 31 December 20X1:

H S
Assets: Rs. m Rs. m
Investment in S: -
First holding (10%) 45 -
Second holding (60%) 540 -
585 -
Other assets 2,500 650
3,085 650
Equity
Share capital 100 100
Retained earnings 2,485 500
2,585 600
Current liabilities 500 50
3,085 650

A consolidated statement of financial position as at 31 December 20X1 can be prepared as follows:

H Group: Consolidated statement of financial position at 31 December 20X1

Rs. m
Assets
Goodwill (see working) 215
Other assets (2,500 + (650 + 150)) 3,300
Total assets 3,515
Equity
Share capital (P only) 100
Consolidated retained earnings (see working) 2,640
2,740
Non-controlling interest (see working) 225
2,965
Current liabilities (500 + 50) 550
Total equity and liabilities 3,515

© Emile Woolf International 35 The Institute of Chartered Accountants of Pakistan

Advanced accounting and financial reporting

At date of At date of Post-

consolidation acquisition acquisition
Share capital 100 100
Retained earnings 500 300 200
Fair value reserve 150 150
Net assets 750 550

Non-controlling interest Rs. m

NCI’s share of net assets at the date of acquisition (30%  550) 165
NCI’s share of the post-acquisition retained earnings of S
(30% of 200 (see above)) 60
NCI’s share of net assets at the date of consolidation
(30%  550) 225

Goodwill
Cost of investment
Cost of second purchase (60%) 540
Fair value of first purchase (10%) – (45 + 15) 60
600
Non-controlling interest at acquisition 165
765
Less: Net assets at acquisition (see above) (550)
215

Consolidated retained earnings:

H’s retained earnings
Per the question 2,485
Gain on remeasurement of previously held equity interest in S (60
 45) 15
2,500
H’s share of the post-acquisition retained earnings of S (70% of
200 (see above)) 140
2,640

© Emile Woolf International 36 The Institute of Chartered Accountants of Pakistan

 Chapter 2: Business combinations achieved in stages

Practice question 1
Company P bought shares in Company T as follows:

Cost Retained
profits
Rs. Rs.
1 January Year 1 40,000 shares 180,000 500,000
30 June Year 4 120,000 shares 780,000 800,000

No fair value adjustments arose on the acquisitions.

Company T had issued share capital of 200,000 Rs. 1 ordinary shares and retained profits at
31 December Year 4 were Rs. 900,000. The fair value of its initial investment in 40,000 shares
of T was Rs. 250,000 at 30 June Year 4.
What is the value goodwill on acquisition.

Practice question 2
Company P bought shares in Company T as follows:

Cost Retained profits

Rs. Rs.
1 January Year 1 40,000 shares 180,000 500,000
30 June Year 4 120,000 shares 780,000 800,000

No fair value adjustments arose on the acquisition. Between 1 January Year 1 and 30 June
Year 4, Company T was treated as an associate and the investment in T was accounted for by
the equity method. There was no impairment in the investment.
Company T had issued share capital of 200,000 Rs. 1 ordinary shares. The fair value of its
initial investment in 40,000 shares of T was Rs. 250,000 at 30 June Year 4.
What gain or loss should be recognised on 30 June Year 4 on the initial investment in 40,000
shares of Company T?

1.2 Purchase of additional equity interest after control is achieved

A company may make a further purchase of shares after control has been achieved.
This is a transaction between the owners of the subsidiary (the controlling interest and the non-
controlling interest) which will cause the non-controlling interest to change.
Any difference between the purchase consideration and the change in the non-controlling interest
is recognised directly in equity.
The equity adjustment

Illustration: Equity adjustment

Rs.
Consideration paid X
Reduction in non-controlling interest at the date of the purchase (X)
Equity adjustment X

© Emile Woolf International 37 The Institute of Chartered Accountants of Pakistan

Advanced accounting and financial reporting

The reduction in non-controlling interest at the date of the purchase is the share of net assets given
up by the non-controlling interest at that date. This requires a working to show the net assets of
the subsidiary at that date.
This is very similar to the goodwill working but this figure is not goodwill. Goodwill arises at the
acquisition date (the date at which control is achieved).
Non-controlling interest (NCI)
The NCI in the statement of financial position at the reporting date is based on the percentage
holdings at that date.
Group policy might be to measure NCI as a proportionate share of net assets at the acquisition
date. In this case the NCI at the reporting date can be easily measured as the NCI share of assets
at that date.
If group policy is to measure NCI at fair value at the acquisition date the calculation can be quite
tricky. In this case, you have to start with the NCI at the acquisition date and adjust it by the
appropriate NCI share of profits since that date. This must be adjusted by NCI share of profits sold
at the date of the second purchase by the parent.

Illustration: Non-controlling interest (NCI)

Rs.

NCI at the date of acquisition (Original NCI %  Net assets at that date) X

NCI’s share of retained earnings of S from the acquisition date to the date of
the second purchase (based on original NCI %) X

NCI’s share of retained earnings of S from the date of the second purchase
to the reporting date (based on the new NCI %) X

Share of profits disposed of at date of second purchase

NCI at the date of consolidation X

This is best demonstrated using figures and is shown in the following example.
Consolidated retained earnings
This must be calculated in the usual way by adding the parent’s share of the subsidiary’s post
acquisition retained profits to those of the parent but remember to make the equity adjustment.
The parent’s share of the subsidiary’s post acquisition retained profits must be measured as two
figures.

Illustration: parent’s share of the subsidiary’s post acquisition retained profits

Rs.

Parent’s share of retained earnings of S from the acquisition date to the date
of consolidation (Original % held) X

Parent’s share of retained earnings of S from date of second purchase to the

date of consolidation (Incremental NCI% held) X

Equity adjustment X/(X)

© Emile Woolf International 38 The Institute of Chartered Accountants of Pakistan

 Chapter 2: Business combinations achieved in stages

Again this is best demonstrated using figures and is shown in the following example. Work through
it carefully.

Example: Purchase of additional equity interest after control is achieved

H bought 60% of S 2 years ago for Rs. 540m. The balance on S’s retained earnings was Rs. 150m.
H bought 10% of S 1 year ago for Rs. 45m. The balance on S’s retained earnings was Rs. 300m at
this date.
Statements of financial position H and S as at 31 December 20X1:

H S
Assets: Rs. m Rs. m
Investment in S: 585 -
Other assets 2,500 650
3,085 650
Equity
Share capital 100 100
Retained earnings 2,485 500
2,585 600
Current liabilities 500 50
3,085 650

The NCI was 40% at the date of the first acquisition and remained the same until the date of the
second purchase at which time it changed to 30%;

A consolidated statement of financial position as at 31 December 20X1 can be prepared as follows:

H Group: Consolidated statement of financial position at 31 December 20X1

Rs. m
Assets
Goodwill (W3) 390
Other assets (2,500 + 650) 3,150
Total assets 3,540
Equity
Share capital (P only) 100
Consolidated retained earnings (see working) 2,710
2,810
Non-controlling interest (see working) 180
2,990
Current liabilities (500 + 50) 550
Total equity and liabilities 3,540

© Emile Woolf International 39 The Institute of Chartered Accountants of Pakistan

Advanced accounting and financial reporting

Example: (continued)

W1: Net assets summary of S

At date of
consolidation 1 year ago 2 years ago
Share capital 100 100 100
Retained earnings 500 300 150
Net assets 600 400 250

W2: Non-controlling interest Rs. m

NCI’s share of net assets at the date of consolidation
(30% of 600 W1 ) 180

A proof of this figure is shown at the end of the example

W3: Goodwill
Cost of investment 540
Non-controlling interest at acquisition (40% of 250) 100
640
Net assets at acquisition (see above) (250)
390

W4: Equity adjustment

Cost of investment 45
Non-controlling interest sold (10% of 400) (40)
5

Consolidated retained profits:

H’s retained earnings 2,485
Equity adjustment W4 (5)
H’s share of the post-acquisition retained earnings of S
(60% of (500  150) W1 210
(10% of (500  300) W1 20
2,710

Non-controlling interest (Proof)

NCI’s share of net assets at the date of acquisition (40%  250) 100
NCI’s share of the post-acquisition retained earnings of S
from date of acquisition to the date of the later purchase
((40% of 300  150) W1)) 60
160

© Emile Woolf International 40 The Institute of Chartered Accountants of Pakistan

 Chapter 2: Business combinations achieved in stages

Example: (continued)

Rs. m
Less movement in NCI at date of second purchase(10% of 400) (40)
NCI’s share of the post-acquisition retained earnings of S
from date of second purchase to the date of consolidation
((30% of 500  300) W1)) 60
NCI’s share of net assets at the date of consolidation
(30% of 600) W1 180

Practice question 3
Company H bought shares in Company S as follows:

Cost Retained
profits
Rs. Rs.
1 January Year 1 120,000 shares 600,000 500,000
30 June Year 4 40,000 shares 270,000 800,000
No fair value adjustments arose on the acquisition.
Company S has issued share capital of 200,000 Rs. 1 ordinary shares.
What was the goodwill arising on the acquisition?

Practice question 4
Company H bought shares in Company S as follows:

Cost Retained
profits
Rs. Rs.
1 January Year 1 120,000 shares 600,000 500,000
30 June Year 4 40,000 shares 270,000 800,000
No fair value adjustments arose on the acquisition. There has been no
impairment of goodwill since the acquisition. No goodwill is attributed to non-
controlling interests.
Company S has issued share capital of 200,000 Rs. 1 ordinary shares.
What journal is required on the acquisition of the 40,000 shares in Company S
on 30 June Year 4?

© Emile Woolf International 41 The Institute of Chartered Accountants of Pakistan

Advanced accounting and financial reporting

2 PATTERN OF OWNERSHIP IN THE CONSOLIDATED STATEMENT OF PROFIT

OR LOSS

Section overview

 Introduction
 Step acquisition
 Purchase of additional equity interest after control is achieved
 Purchase turning significant influence into control

2.1 Introduction
The pattern of ownership must be reflected in the statement of profit or loss and other
comprehensive income.
A change in ownership in the period will have an impact on the consolidated statement of profit or
loss and other comprehensive income.

Illustration: Pattern of ownership

Date of
acquisition Year end

Situation 1 is the basic situation which you will have seen before. The results must be consolidated
from the date that control is achieved.
Situations 2 to 4 are explained in more detail in the following sections

© Emile Woolf International 42 The Institute of Chartered Accountants of Pakistan

 Chapter 2: Business combinations achieved in stages

2.2 Step acquisition

Situation 2: In this case the parent had a previously held equity interest. This gave the parent no
influence. Control was achieved by the second acquisition and consolidation commences from that
point.

Example: Step acquisition

H has owned 10% of S for several years
H bought a further 60% of S on 30th September 20X1.
Statements of profit or loss for the year ended 31 December 20X1:

H S
Rs. m Rs. m
Revenue 10,000 6,000
Cost of sales (7,000) (4,800)
Gross profit 3,000 1,200
Expenses (1,000) (300)
Profit before tax 2,000 900
Income tax (500) (160)
Profit after tax 1,500 740

A consolidated statement of comprehensive income can be prepared as follows:

Working
H S (3/12) Consolidated
Rs. Rs. Rs.
Revenue 10,000 1,500 11,500
Cost of sales (7,000) (1,200) (8,200)
Gross profit 3,000 300 3,300
Expenses (1,000) (75) (1,075)
Profit before tax 2,225
Income tax expense (500) (40) (540)
Profit for the period 1,500 185 1,685

Total comprehensive income attributable to:

Owners of the parent (balancing figure) 1,629
Non-controlling interests (30% of 185) 56
1,685

© Emile Woolf International 43 The Institute of Chartered Accountants of Pakistan

Advanced accounting and financial reporting

2.3 Purchase of additional equity interest after control is achieved

Situation 3: In this case the parent has a subsidiary for the whole year. Therefore, the results of
that subsidiary must be consolidated for the whole year. However, the pattern of ownership
changes during the year. The pattern of ownership is reflected in the statement of profit or loss by
applying the appropriate NCI to the results for that part of the year in which that NCI was valid.

Example:
H has owned 60% of S for several years
H bought a further 10% of S on 30th September 20X1.
Statements of profit or loss for the year ended 31 December 20X1:
H S
Rs. m Rs. m
Revenue 10,000 6,000
Cost of sales (7,000) (4,800)
Gross profit 3,000 1,200
Expenses (1,000) (300)
Profit before tax 2,000 900
Income tax (500) (160)
Profit after tax 1,500 740

A consolidated statement of comprehensive income can be prepared as follows:

Working
H S Consolidated
Rs. Rs. Rs.
Revenue 10,000 6,000 16,000
Cost of sales (7,000) (4,800) (11,800)
Gross profit 3,000 1,200 4,200
Expenses (1,000) (300) (1,300)
Profit before tax 2,000 900 2,900
Income tax expense (500) (160) (660)
Profit for the period 1,500 740 2,240

Total comprehensive income attributable to:

Owners of the parent (balancing figure) 1,962
Non-controlling interests
40%  9/12  740 222
30%  3/12  740 56
278
2,240

© Emile Woolf International 44 The Institute of Chartered Accountants of Pakistan

 Chapter 2: Business combinations achieved in stages

2.4 Purchase turning significant influence into control

Situation 4: In this case the parent had significant influence in the first part of the years and then
made an acquisition which achieved control. The results for the year must be split into two parts.
The results for the period in which the parent had significant influence must be equity accounted.
The results for the period in which the parent had control must be consolidated.

Example: Step acquisition (associate to subsidiary)

H has owned 40% of S for several years. This holding gave H significant influence over S.
H bought a further 30% of S on 30th September 20X1.
Statements of profit or loss for the year ended 31 December 20X1:

H S
Rs. m Rs. m
Revenue 10,000 6,000
Cost of sales (7,000) (4,800)
Gross profit 3,000 1,200
Expenses (1,000) (300)
Profit before tax 2,000 900
Income tax (500) (160)
Profit for the period 1,500 740

A consolidated statement of comprehensive income can be prepared as follows:

Working
H S (3/12) Consolidated
Rs. Rs. Rs.
Revenue 10,000 1,500 11,500
Cost of sales (7,000) (1,200) (8,200)
Gross profit 3,000 300 3,300
Expenses (1,000) (75) (1,075)
Share of profit of
associate
(40%  9/12  740) 222
Profit before tax 2,447
Income tax expense (500) (40) (540)
Profit for the period 1,500 185 1,907

Total comprehensive income attributable to:

Owners of the parent (balancing figure) 1,851
Non-controlling interests (30% of 185) 56
1,907

© Emile Woolf International 45 The Institute of Chartered Accountants of Pakistan

Advanced accounting and financial reporting

SOLUTIONS TO PRACTICE QUESTIONS

Solution 1
Goodwill is calculated when control is acquired (IFRS 3).

Rs.
Fair value of original investment 250,000
Cost of additional shares 780,000
Cost of investment to acquire T 1,030,000
Less: Net assets acquired (160/200  (800 + 200)) (800,000)
Goodwill 230,000

Goodwill is calculated when control is acquired (IFRS 3)

Solution 2
A step acquisition occurs in June Year 4. The original investment is revalued at fair value.

Rs.
Cost of original investment 180,000
Share of retained profits of associate (20%  (800 – 500) 60,000
240,000
Less: Fair value of original investment (250,000)
Gain recognised in profit or loss (10,000)

Goodwill is calculated when control is acquired (IFRS 3)

Solution 3
Goodwill is calculated when control is acquired (IFRS 3). This is on purchase of the first
investment.

Rs.
Fair value of original investment 600,000
Less: Net assets acquired (120/200  (500 + 200)) (420,000)
Goodwill 180,000

© Emile Woolf International 46 The Institute of Chartered Accountants of Pakistan

 Chapter 2: Business combinations achieved in stages

Solution 4
Dr Cr
Equity attributable to parent Rs. 70,000
Non-controlling interest Rs. 200,000
Bank Rs. 270,000
The acquisition of the extra 40,000 shares does not affect control of Company S, and it is therefore
accounted for as an equity transaction between equity owners of the company in their capacity as
owners. IAS 27 states that any difference between cash paid and the adjustment made to NCI is
attributed to parent equity

© Emile Woolf International 47 The Institute of Chartered Accountants of Pakistan

Advanced accounting and financial reporting

© Emile Woolf International 48 The Institute of Chartered Accountants of Pakistan

 Certified Finance and Accounting Professional

CHAPTER
Advanced accounting and financial reporting

Consolidated statements of profit or loss

and other comprehensive income

Contents
1 Consolidated statement of profit or loss
2 Consolidated statement of other comprehensive income

© Emile Woolf International 49 The Institute of Chartered Accountants of Pakistan

Advanced accounting and financial reporting

1 CONSOLIDATED STATEMENT OF PROFIT OR LOSS

Section overview

 The basic rules

 Inter-company items
 Other adjustments
 Pre-acquisition and post-acquisition profits

1.1 The basic rules

A consolidated statement of profit or loss brings together the sales revenue, income and expenses
of the parent and of its subsidiaries.
Similarly, a consolidated statement of other comprehensive income brings together the gains and
losses of the parent and of its subsidiaries.
In the consolidated statements, all items of income, expenses, gains and losses are a straight
cross cast of equivalent items in the individual financial statements of the members of the group.
Non-controlling interest
Consolidated financial statements must also disclose the profit or loss for the period and the total
comprehensive income for the period attributable to:
 owners of the parent company; and
 non-controlling interests.
The figure for NCI is simply the parent’s share of the subsidiary’s profit for the year that has been
included in the consolidated statement of comprehensive income.
The amounts attributable to the owners of the parent and the non-controlling interest are shown as
a metric (small table) immediately below the statement of comprehensive income.

Illustration: Amounts attributable to the owners of the parent and the non-controlling interest
Profit attributable to: Rs.
Owners of the parent (balancing figure) X
Non-controlling interests (x% of y) X
X
Where: x% is the NCI ownership interest
y is the subsidiary’s profit for the year that has been included in the consolidated
statement of comprehensive income

1.2 Inter-company items

Consolidated statements of profit or loss are prepared by combining the information given in the
statements of profit or loss of the individual companies.
It is usually necessary to make adjustments to eliminate the results of inter-company trading. This
includes adjustments to cancel out inter-company trading balances and unrealised profit.
Inter-company trading
Inter-company trading will be included in revenue of one group company and purchases of another.
These are cancelled on consolidation.

© Emile Woolf International 50 The Institute of Chartered Accountants of Pakistan

 Chapter 3: Consolidated statements of profit or loss and other comprehensive income

Illustration: Debit Credit

Revenue X
Cost of sales (actual purchases within cost of sales) X

Unrealised profits on trading

If any item is sold by one group company to another, it will be included in inventory (i.e. have not
been sold on outside the group by the year end), their value must be adjusted to lower of cost and
net realisable value from the group viewpoint (as for the consolidated statement of financial
position).
Below is the double entry in respect of inventory valuation adjustment made in the consolidated
financial statements.

Illustration: Debit Credit

Closing inventory – Statement of comprehensive income X
Closing inventory – Statement of financial position X

The adjustment in the statement of comprehensive income reduces gross profit and hence profit
for the year. The NCI share in this reduced figure and the balance is added to retained earnings.
Thus, the adjustment is shared between both ownership interests.
If the sale is from S to P the unrealised profit adjustment must be shared with the NCI.
Inter-company management fees and interest
All other inter-company amounts must also be cancelled.
Where a group company charges another group company, management fees/interest, there is no
external group income or external group expense and they are cancelled one against the other like
inter-company sales and cost of sales.

Illustration: Debit Credit

Income (management fees) X
Expense (management charges) X

Inter-company dividends
The parent may have accounted for dividend income from a subsidiary in their standalone financial
statements as dividend income. But this is cancelled on consolidation.
Dividends received from a subsidiary are ignored in the consolidation of the statement of
comprehensive income because the profit out of which they are paid has already been
consolidated.

1.3 Other adjustments

Fair value adjustments
Assets such as property, plant and equipment, or inventory will be recognised in the subsidiary’s
financial statements at their carrying amounts. Adjustments must be made to reflect the fair value
of these assets.
For example, inventory must be held in the financial statements of the subsidiary at the lower of
cost and net realisable value, but must be recognised in the consolidated financial statements at
fair value on acquisition.
Another example would be of depreciation on non-current assets. Depreciation is charged on the
carrying amount of assets if an entity adopts policy of cost model.

© Emile Woolf International 51 The Institute of Chartered Accountants of Pakistan

Advanced accounting and financial reporting

However, if a parent company accounting policy is of revaluation for that asset then fair value
adjustment will arise. The depreciation stream that relates to the revalued asset will also need to
be adjusted on consolidation.
Accounting for Impairment of goodwill
When purchased goodwill is impaired, the impairment does not affect the individual financial
statements of the parent company or the subsidiary. The effect of the impairment applies
exclusively to the consolidated statement of financial position and the consolidated income
statement.
If goodwill is impaired:
 It is written down in value in the consolidated statement of financial position, and
 The amount of the write-down is charged as an expense in the consolidated income
statement (normally in administrative expenses).

Practice question 1
P acquired 80% of S 3 years ago. Goodwill on acquisition was Rs. 80,000. The recoverable amount
of goodwill at the year-end was estimated to be Rs. 65,000. This was the first time that the
recoverable amount of goodwill had fallen below the amount at initial recognition.
S sells goods to P. The total sales in the year were Rs. 100,000. At the year-end P retains inventory
from S which had cost S Rs. 30,000 but was in P’s books at Rs. 35,000.
The distribution costs of S include depreciation of an asset which had been subject to a fair value
increase of Rs. 100,000 on acquisition. This asset is being written off on a straight line basis over 10
years.
The statements of profit or loss for the year to 31 December 20X1 are as follows:
P S
Rs.(000) Rs.(000)
Revenue 1,000 800
Cost of sales (400) (250)
Gross profit1 600 550
Distribution costs (120) (75)
Administrative expenses (80) (20)
400 455
Dividend from S 80 -
Finance cost (25) (15)
Profit before tax 455 440
Tax (45) (40)
Profit for the period 410 400

Prepare the consolidated income statement for the year ended 31 December.

1.4 Pre-acquisition and post-acquisition profits

A change in ownership in the period will have an impact on the consolidated statement of profit or
loss and other comprehensive income.
The financial statements of a subsidiary must be consolidated from the date control is achieved
until the date that control is lost. In other words, the pattern of ownership must be reflected in the
statement of profit or loss and other comprehensive income.

© Emile Woolf International 52 The Institute of Chartered Accountants of Pakistan

 Chapter 3: Consolidated statements of profit or loss and other comprehensive income

 All of an entity’s results are consolidated if it is controlled for the whole year
 If an entity is controlled for only part of the year, only those results that relate to that part of
the year are consolidated.
For example, if a parent acquires a subsidiary during a financial year, the profits of the subsidiary
have to be divided into pre-acquisition and post-acquisition and only post acquisition profits are
consolidated.
The following straightforward example is of a type that you have seen in previous papers. Later
chapters on step acquisitions and disposals will show more complex applications of the principle.

Example: Consolidated statement of profit or loss (mid-year acquisition)

Entity P acquired 80% of S on 1 October 20X1.
The statements of profit or loss for the year to 31 December 20X1 are as follows:

P S
Rs. Rs.
Revenue 400,000 260,000
Cost of sales (200,000) (60,000)
Gross profit 200,000 200,000
Other income 20,000 -
Distribution costs (50,000) (30,000)
Administrative expenses (90,000) (95,000)
Profit before tax 80,000 75,000
Income tax expense (30,000) (15,000)
Profit for the period 50,000 60,000

A consolidated statement of comprehensive income can be prepared as follows:

Working
P S (3/12) Consolidated
Rs. Rs. Rs.
Revenue 400,000 65,000 465,000
Cost of sales (200,000) (15,000) (215,000)
Gross profit 200,000 50,000 250,000
Other income 20,000 – 20,000
Distribution costs (50,000) (7,500) (57,500)
Administrative expenses (90,000) (23,750) (113,750)
Profit before tax 80,000 18,750 98,750
Income tax expense (30,000) (3,750) (33,750)
Profit for the period 50,000 15,000 65,000

Total comprehensive income attributable to:

Owners of the parent (balancing figure) 62,000
Non-controlling interests (20% of 15,000) 3,000
65,000

© Emile Woolf International 53 The Institute of Chartered Accountants of Pakistan

Advanced accounting and financial reporting

2 CONSOLIDATED STATEMENT OF OTHER COMPREHENSIVE INCOME

Section overview

 A single statement or two statements

 Consolidation of other comprehensive income

2.1 A single statement or two statements

The statement of comprehensive income includes both profit or loss and other comprehensive
income that provides information about the performance of an entity in a period. It consists of two
parts:
 profit or loss – a list of income and expenses which result in a profit or loss for the period;
and
 other comprehensive income – a list of other (unrealised) gains and losses that have arisen
in the period and are therefore, recorded outside statement of profit or loss.
IAS 1 allows an entity to present the two sections in a single statement or in two separate
statements.
Information to be presented in the other comprehensive income section
The other comprehensive income section must present line items for amounts of other
comprehensive income in the period, classified by nature (including share of the other
comprehensive income of associates and joint ventures accounted for using the equity method)
and grouped into those that, in accordance with other IFRSs:
 will not be reclassified subsequently to profit or loss:

 revaluation surpluses on property, plant and equipment (IAS 16)

 revaluation surpluses on intangible assets (IAS 38)
 remeasurements of defined benefit pension schemes (IAS 19); and
 will be reclassified subsequently to profit or loss when specific conditions are met, including:
 gains and losses on retranslation of foreign operations (IAS 21);
 unrealised gains and losses on securities
 gains and losses recognised on the effective element of cash flow hedges (IAS 39)

2.2 Consolidation of other comprehensive income

Consolidation of the statement of other comprehensive income is carried out in a similar way to
the consolidation of the statement of profit or loss.
In the consolidated statements, all items of income, expenses, gains and losses are a straight
cross cast of equivalent items in the individual financial statements of the members of the group.
Items in the statement of other comprehensive income are unlikely to be affected by inter-company
trading or similar issues.
Non-controlling interest
Profit or loss and other comprehensive income in the period together are described as total
comprehensive income for the period.
Consolidated financial statements must disclose total comprehensive income for the period
attributable to the

© Emile Woolf International 54 The Institute of Chartered Accountants of Pakistan

 Chapter 3: Consolidated statements of profit or loss and other comprehensive income

 owners of the parent company; and

 non-controlling interests.
This is in addition to the disclosure for profit or loss described earlier.
The figure for NCI is simply their share of the subsidiary’s other comprehensive income for the year
that has been included in the consolidated statement of other comprehensive income.
The amounts attributable to the owners of the parent and the non-controlling interest are shown as
a metric (small table) immediately below the statement of comprehensive income.

Illustration: Amounts attributable to the owners of the parent and the non-controlling interest

Total comprehensive income attributable to: Rs.

Owners of the parent (balancing figure) X
Non-controlling interests X
X

Example: Consolidated statement of profit or loss and other comprehensive income

Entity P acquired 80% of S several years ago.
Entity P presents the statement of profit or loss and other comprehensive income as a single
statement. Items in other comprehensive income are shown net of tax.
The summarised statements of profit or loss and other comprehensive income for the year to 31
December 20X1 are as follows:

P S
Profit or loss Rs. Rs.
Revenue 400,000 260,000
Cost of sales (200,000) (60,000)
Gross profit 200,000 200,000
Expenses (90,000) (95,000)
Profit before tax 110,000 105,000
Income tax expense (30,000) (15,000)
Profit for the year 80,000 90,000
Other comprehensive income
Items that will not be reclassified to profit or loss
Remeasurement of defined benefit plan 2,000 1,000
Items that may be reclassified to profit or loss
Cash flow hedge (1,200) 400
Other comprehensive income for the year 800 1,400
Total comprehensive income for the year 80,800 91,400
A consolidated statement of profit or loss and other comprehensive income can be prepared as
follows:

© Emile Woolf International 55 The Institute of Chartered Accountants of Pakistan

Advanced accounting and financial reporting

Example (continued): Consolidated statement of profit or loss and other comprehensive income

A consolidated statement of profit or loss and other comprehensive income can be prepared as
follows:
Working
P S Consolidated
Rs. Rs. Rs.
Revenue 400,000 260,000 660,000
Cost of sales (200,000) (60,000) (260,000)
Gross profit 200,000 200,000 400,000
Expenses (90,000) (95,000) (185,000)
Profit before tax 215,000
Income tax expense (30,000) (15,000) (45,000)
Profit for the period 80,000 90,000 170,000

Other comprehensive
income
Items that will not be
reclassified…
Remeasurement of
defined benefit plan 2,000 1,000 3,000

Items that may be

reclassified …..
Cash flow hedge (1,200) 400 (800)
Other comprehensive
income for the year 800 1,400 2,200
Total comprehensive
income for the year 91,400 172,200

Profit attributable to:

Owners of the parent (balancing figure) 152,000
Non-controlling interests (20% of 90,000) 18,000
170,000

Total comprehensive income attributable to:

Owners of the parent (balancing figure) 62,000
Non-controlling interests (20% of 91,400) 18,820
153,380

© Emile Woolf International 56 The Institute of Chartered Accountants of Pakistan

 Chapter 3: Consolidated statements of profit or loss and other comprehensive income

SOLUTIONS TO PRACTICE QUESTIONS

Solutions 1
Consolidated statement of comprehensive income for the year ended 31 December.

Workings
P S Dr Cr Consol.
Rs.(000) Rs.(000) Rs.(000) Rs.(000) Rs.(000)
Revenue 1,000 800 (100) 1,700
Cost of sales (400) (250) 3(5) 100 (555)
Gross profit 600 550 (105) 100 1,145
Distribution costs (120) (75)
Fair value adjustment 1(10)

(120) (85) (205)

Administrative expenses (80) (20) 2(15) (115)
400 445
Dividend from S 80 - (80)
Finance cost (25) (15) (40)
Profit before tax 455 430 785
Tax (45) (40) (85)
Profit for the period 410 390 (200) 100 700

Total comprehensive income attributable to: Rs.(000)

Owners of the parent (balancing figure) 633
Non-controlling interests (20% of 390,000)  (20% of 35,000) 77
700
Notes:
1: Extra depreciation on fair value adjustment (100/10 years)
2: Goodwill impairment
3: Unrealised profit

© Emile Woolf International 57 The Institute of Chartered Accountants of Pakistan

Advanced accounting and financial reporting

© Emile Woolf International 58 The Institute of Chartered Accountants of Pakistan

 Certified Finance and Accounting Professional

CHAPTER
Advanced accounting and financial reporting

Complex groups

Contents
1 Introduction
2 Consolidation of sub-subsidiaries (two stage method)
3 Consolidation of mixed groups
4 Other issues

© Emile Woolf International 59 The Institute of Chartered Accountants of Pakistan

Advanced accounting and financial reporting

1 INTRODUCTION
Section overview

 Vertical and mixed groups

 Date of acquisition of the sub-subsidiary

1.1 Vertical and mixed groups

A subsidiary is an entity controlled by another entity (its parent company) either directly or indirectly
through one or more intermediaries. A group structure in which a parent has a subsidiary and that
subsidiary is itself a parent of another subsidiary (sub-subsidiary of ultimate parent) is known as a
vertical group.
In the following explanation we shall refer to the parent as H, its subsidiary as S and the sub-
subsidiary as T.

Illustration: Vertical group

H Ltd owns 75% of S Ltd. S Ltd is thus a subsidiary of H Ltd.

S Ltd owns 60% of T Ltd. T Ltd is a subsidiary of S Ltd.
T Ltd is also a subsidiary of H Ltd.

Explanation
H Ltd has a direct interest in S Ltd and an indirect interest in T Ltd (exercised via S Ltd’s holding in
T Ltd).
T Ltd is a subsidiary of H Ltd because H Ltd has a controlling interest in S Ltd and S Ltd has a
controlling interest in T Ltd.
This is a ‘vertical group’ consisting of H Ltd, S Ltd and T Ltd.
T Ltd is said to be a sub-subsidiary of H Ltd.

In practice, structures can be much more complex than this with groups comprised of many layers
of companies. However, they will be consolidated by applying the same principles as explained in
this chapter for the relatively straightforward vertical group structure shown above.
Another group structure that could be examined is a mixed group (also known as a D-shaped
group).

Illustration: Mixed group

H Ltd owns 60% of S Ltd and 40% of T Ltd

S Ltd owns 20% of T Ltd.
S Ltd is a subsidiary of H Ltd.
T Ltd is also a subsidiary of H Ltd.

Explanation
H Ltd has an equity interest in S Ltd that gives it more than 50% shareholding. Further, H Ltd. has
a significant influence (40%) and S Ltd further owns 20% in T Ltd.
H Ltd controls T Ltd because it owns 40% directly and because it controls another 20% through its
control of S Ltd. Indirect holding of H Ltd in T Ltd is 52% (40% + (60%*20%)).

© Emile Woolf International 60 The Institute of Chartered Accountants of Pakistan

 Chapter 4: Complex groups

It is the control and not ownership that is relevant in deciding whether a company is consolidated in
a group. H is referred to as the ultimate parent company of T. Even if the effective holding is less than
50% of sub-subsidiary, the results are consolidated as far as subsidiary of a parent controls sub-
subsidiary.
You may also come across examples where there is a sub-associate. This will be covered in a
later section of this chapter.
Status of the investment
The starting point in any question involving a complex structure is to draw a diagram of the group
and then decide on the status of the bottom company in relation to the ultimate parent.
The bottom company will either be a sub-subsidiary as shown above or a sub-associate. The status
of the bottom investment is always decided in terms of whether H can exercise control or significant
influence either directly or indirectly.

1.2 Date of acquisition of the sub-subsidiary

A subsidiary must be consolidated from the date of acquisition. The issue is the date of acquisition
of the sub-subsidiary. It is not always obvious as to what that date should be.
The acquisition date for a sub-subsidiary in a vertical group depends on whether:
 the holding company H acquired its shares in subsidiary S before S acquired its shares in
the sub-subsidiary T; or
 the holding company H acquired its shares in subsidiary S after S acquired its shares in the
sub-subsidiary T.
The date of acquisition of the sub-subsidiary is the later of the date on which the main subsidiary
(S) was purchased by the parent and the date on which the sub-subsidiary (T) was purchased by
the main subsidiary (S).
In other words:
 Situation 1: If the holding company H acquired its shares in subsidiary S before S acquired
its shares in the sub-subsidiary T, the date that T becomes a member of the H Group is the
date when S acquired the shares in T.
 Situation 2: If the holding company H acquired its shares in subsidiary S after S acquired
its shares in the sub-subsidiary T, the date that T becomes a member of the H Group is the
date when H acquired its shares in S.

Illustration: Date of acquisition – Situation 1

Explanation
H acquired 75% of S on 1 January 20X1.
S acquired 60% of T two years later on 1 January 20X3.
H acquired control of T when S bought its interest on 1 January 20X3. Therefore, the date of
acquisition of T Ltd from H Ltd’s viewpoint is 1 January 20X3.

© Emile Woolf International 61 The Institute of Chartered Accountants of Pakistan

Advanced accounting and financial reporting

Illustration: Date of acquisition – Situation 2

Explanation
H acquired 75% of S on 1 January 20X3.
S already held 60% of T.
H therefore acquired control of S and T at the same date.
Therefore, the date of acquisition of T Ltd from H Ltd’s viewpoint is 1 January 20X3.

© Emile Woolf International 62 The Institute of Chartered Accountants of Pakistan

 Chapter 4: Complex groups

2 CONSOLIDATION OF SUB-SUBSIDIARIES (TWO STAGE METHOD)

Section overview

 Consolidation of sub-subsidiaries: Two methods

 Indirect method (2 stages)
 Direct method (1 stage)
 Rationale for splitting the cost of investment when using the direct method

2.1 Consolidation of sub-subsidiaries: Two methods

There are two methods (direct and indirect) which can be used for dealing with sub-subsidiaries.
The different methods may result in different balances for certain items.

2.2 Indirect method (2 stages)

The consolidation takes place in two stages. Firstly, the S group accounts are prepared by
consolidating T into S. Then, the S group accounts are consolidated into H.

Example: Consolidation of sub-subsidiary using the indirect method

H Ltd acquired 75% of S Ltd on 1 January 20X4 when the retained profits of S were Rs. 40,000.
S Ltd acquired 60% of T Ltd on 30 June 20X4 when the retained profits of T Ltd were Rs. 25,000.
They had been Rs. 20,000 on the date of H Ltd’s acquisition of S Ltd.
Draft statements of financial position of H Ltd, S Ltd and T Ltd, as at 31 December 20X4, are as
follows:
H Ltd S Ltd T Ltd
Rs. ’000 Rs. ’000 Rs. ’000
Other assets 280 110 100
Investment in S 120
Investment in T 80
400 190 100

Share capital 200 100 50

Retained profits 100 60 30
Liabilities 100 30 20
400 190 100
A consolidated statement of financial position as at 31 December 20X4 can be prepared as follows:
Step 1: Consolidate S Ltd and T Ltd
S Sub-Group: Consolidated statement of financial position at 31 December 20X4
Assets Rs. 000
Goodwill (W2) 35.00
Other assets (110 + 100) 210.00
Total assets 245.00
Equity
Share capital 100.00
Consolidated retained profits (W4) 63.00
163.00
Non-controlling interest (W3) 32.00
195.00
Current liabilities (30 + 20) 50.00
Total equity and liabilities 245.00

© Emile Woolf International 63 The Institute of Chartered Accountants of Pakistan

Advanced accounting and financial reporting

Example: (continued)
W1: Net assets summary of T
At date of At date of Post-
consolidation acquisition acquisition
Share capital 50 50
Retained profits 30 25 5
Net assets 80 75

W2: Goodwill (on acquisition of T) Rs. 000

Cost of investment 80.00
Non-controlling interest at acquisition (40%  75) 30.00
110.00
Net assets at acquisition (W1) (75.00)
35.00
W3: NCI in T
NCI’s share of net assets at the date of acquisition
(40%  75) 30.00
NCI’s share of the post-acquisition retained profits of S
(40% of 5 (W1)) 2.00
32.00
W4: Consolidated retained profits:
All of S’s retained profits 60.00
S’s share of the post-acquisition retained profits of T
(60% of 5 (W1)) 3.00
63.00
Step 2: Consolidate H Ltd and S Group
H-Group: Consolidated statement of financial position at 31 December 20X4
Rs. 000
Assets
Goodwill (15 (W2) + 35 (step 1)) 50.00
Other assets (280 + 210 (step1)) 490.00
Total assets 540.00
Equity
Share capital 200.00
Consolidated retained profits (W4) 117.25
317.25
Non-controlling interest (40.75 (W3) + 32 (step 1)) 72.75
390.00
Current liabilities (100 + 50 (step1)) 150.00
Total equity and liabilities 540.00

W1: Net assets summary of S

At date of At date of Post-
consolidation acquisition acquisition
Share capital 100 100
Retained profits (step 1) 63 40 23
Net assets 163 140

© Emile Woolf International 64 The Institute of Chartered Accountants of Pakistan

 Chapter 4: Complex groups

Example: (continued)
W2: Goodwill (on acquisition of S) Rs. 000
Cost of investment 120.00
Non-controlling interest at acquisition (25%  140) 35.00
155.00
Net assets at acquisition (W1) (140.00)
15.00
W3: NCI in S
NCI’s share of net assets of at the date of acquisition
(25%  140) 35.00
NCI’s share of the post-acquisition retained profits of S
(25% of 23 (W1)) 5.75
40.75
W4: Consolidated retained profits:
H’s retained profits 100.00
H’s share of the post-acquisition retained profits of S Group
(75%  23) 17.25
117.25

In the above example H bought S before S had bought its interest in T. If H bought S after S had
bought its interest in T it would be necessary to calculate the consolidated net assets of the S
group at the date of its acquisition by H.
The indirect method is the way that most groups would perform consolidation in practice. However,
examiners usually expect the use of the direct approach when answering exam questions.

2.3 Direct method (1 stage)

This approach involves identifying H’s effective holding in the sub-subsidiary and then using this
to consolidate the sub-subsidiary directly along with the main subsidiary.

Illustration: Effective holding

H Ltd owns 75% of S Ltd.

S Ltd owns 60% of T Ltd.
H Ltd effectively owns 45% (75% of 60%) of T Ltd

Comment
H Ltd will consolidate a 75% of interest in S Ltd. The non-controlling interest in S Ltd is
25%.
H Ltd will consolidate a 45% of interest in S Ltd. The non-controlling interest in S Ltd is 55%
(taken as a balancing figure).
Do not be confused by the existence of a non-controlling interest of 55%. Remember that
we have already established that T is a subsidiary of H. The effective interests are
mathematical conveniences which allow us to produce the consolidation. (Ownership and
control are two separate issues).

© Emile Woolf International 65 The Institute of Chartered Accountants of Pakistan

Advanced accounting and financial reporting

The main subsidiary is consolidated by the parent in the usual way.

The sub-subsidiary is also consolidated by the parent in the usual way using the effective holding
with one further adjustment. The cost of investment in T is split. H’s share is used in the goodwill
working and the balance is charged to the non-controlling interest.
To illustrate, in the next example the cost of investment in T is Rs. 80,000. This number is split so
that H’s share of Rs. 60,000 (75%  Rs. 80,000) is the cost used in the goodwill calculation and
the balance Rs. 20,000 (25%  Rs. 80,000) is a deduction from the non-controlling interest.

Example: Consolidation of sub-subsidiary using the direct method

H Ltd acquired 75% of S Ltd on 1 January 20X4 when the retained profits of S were Rs. 40,000.
S Ltd acquired 60% of T Ltd on 30 June 20X4 when the retained profits of T Ltd were Rs. 25,000.
They had been Rs. 20,000 on the date of H Ltd’s acquisition of S Ltd.
Draft statements of financial position of H Ltd, S Ltd and T Ltd, as at 31 December 20X4, are as
follows:
H Ltd S Ltd T Ltd
Rs. ’000 Rs. ’000 Rs. ’000
Other assets 280 110 100
Investment in S 120
Investment in T 80
400 190 100

Share capital 200 100 50

Retained profits 100 60 30
Liabilities 100 30 20
400 190 100

A consolidated statement of financial position as at 31 December 20X4 can be prepared as follows:

H Group: Consolidated statement of financial position at 31 December 20X4
Rs. 000
Assets
Goodwill (W2) 41.25
Other assets (280 + 110 + 100) 490.00
Total assets 531.25
Equity
Share capital 200.00
Consolidated retained profits (W4) 117.25
317.25
Non-controlling interest (W3) 64.00
381.25
Current liabilities 150.00
Total equity and liabilities 531.25

W1a: Net assets summary of S

At date of At date of Post-
consolidation acquisition acquisition
Share capital 100 100
Retained profits 60 40 20
Net assets 160 140

© Emile Woolf International 66 The Institute of Chartered Accountants of Pakistan

 Chapter 4: Complex groups

Example: (continued)
W1b: Net assets summary of T
At date of At date of Post-
consolidation acquisition acquisition
Share capital 50 50
Retained profits 30 25 5
Net assets 80 75

W2: Goodwill Rs. 000

On acquisition of S
Cost of investment 120.00
Non-controlling interest at acquisition (25%  140 (W1a)) 35.00
155.00
Net assets at acquisition (see above) (140.00)
15.00
On acquisition of T
Cost of investment (75%  80) 60.00
Non-controlling interest at acquisition (55%  75 (W1b)) 41.25
101.25
Net assets at acquisition (see above) (75.00)
26.25
Total goodwill 41.25

W3: Non-controlling interest

NCI in S
NCI’s share of net assets of at the date of acquisition
(25%  140 (W1a)) 35.00
NCI’s share of the post-acquisition retained profits of S
(25% of 20 (W1a)) 5.00
NCI’s share of net assets at the date of consolidation 40.00
NCI in T
NCI’s share of net assets of at the date of acquisition
(55%  75(W1b)) 41.25
NCI’s share of the post-acquisition retained profits of S
(55% of 5 (W1b)) 2.75
NCI’s share of net assets at the date of consolidation 44.00
Less NCI in S share of cost of investment in T (25%  80) (20.00)
24.00
Total NCI 64.00
W4: Consolidated retained profits:
H’s retained profits 100.00
H’s share of the post-acquisition retained profits of S
(75% of 20 (W1a)) 15.00
H’s share of the post-acquisition retained profits of T
(45% of 5 (W1b)) 2.25
117.25

© Emile Woolf International 67 The Institute of Chartered Accountants of Pakistan

Advanced accounting and financial reporting

2.4 Rationale for splitting the cost of investment when using the direct method
Goodwill
Goodwill is the difference between the cost of investment and the share of net assets acquired.
This is not obvious from the format of the calculation but it can be rearranged to demonstrate this
as follows:
Example: Goodwill on acquisition
Returning to the facts of the previous example:
Goodwill on acquisition of S Rs. 000
Cost of investment 120.00
Non-controlling interest at acquisition (25%  140) 35.00
155.00
Net assets at acquisition (see above) (140.00)
15.00
This could be rearranged to:
Cost of investment 120.00
Less: Share of net assets at acquisition
Net assets at acquisition (see above) 140.00
Non-controlling interest at acquisition (35.00)
(75%  140) 105.00
15.00

The effective interest is the parent’s share of the main subsidiaries share of the sub-subsidiary.
 Goodwill calculated for the main subsidiary is cost less share of net assets.
 Goodwill calculated for the sub-subsidiary must be the share of cost less share of share of
net assets.
Non-controlling interest
In previous examples, the NCI in the sub-subsidiary was calculated as a balancing figure. It is
possible to prove this figure in terms of the shareholdings of the main subsidiary and the sub-
subsidiary.

Illustration: Non-controlling interest

Comment
H Ltd has an effective interest of 45% of T (75%  60%).
The NCI is 55% (taken as a balancing figure).
The NCI in the sub-subsidiary is made up of the following:
NCI in T 40%
NCI in S’s share of investment in T (25%  60%) 15%
55%

© Emile Woolf International 68 The Institute of Chartered Accountants of Pakistan

 Chapter 4: Complex groups

Consolidation involves replacing cost of investment with a share of net assets. Using the effective
interest to calculate the NCI in the sub-subsidiary gives the NCI in the main subsidiary a share of
the net assets of the sub-subsidiary (see the 15% above). However, the NCI in the main subsidiary
has already been given a share of the net assets of the main subsidiary and this includes the cost
of investment in T. Therefore, the NCI in the main subsidiary’s share of cost must be eliminated to
avoid double counting.
This sounds more complicated than it is. Always split the cost of investment in the sub-subsidiary
as shown in the worked example.

Practice question 1
The statements of financial position H, S and T as at 31 December 20X7 were as
follows:
Assets: H (Rs.) S(Rs.) T(Rs.)
Investment in S 5,000

Investment in T 750
Other assets 11,900 6,000 1,500

16,900 6,750 1,500

Equity
Share capital 10,000 3,000 300
Retained profits 4,900 2,750 700
Liabilities 2,000 1,000 500

16,900 6,750 1,500

H acquired its 80% investment in S on 1 January 20X7.

S acquired its 60% investment in T on 1 January 20X4.
At the dates of the share purchases, the following information is available:
Retained Retained
Date profits of S profits of T
1 January 20X4 2,000 500
1 January 20X7 2,300 650
Required
Prepare the consolidated statement of financial position for the H Group as at 31 December
20X7.

© Emile Woolf International 69 The Institute of Chartered Accountants of Pakistan

Advanced accounting and financial reporting

Practice question 2
The statements of financial position H, S and T as at 31 December 20X8 were as
follows:
H S T
(Rs. 000) (Rs. 000) (Rs. 000)
Assets:
Investment in S 3,300

Investment in T 2,200
Other assets 3,700 2,400 3,500

7,000 4,600 3,500

Equity
Share capital 4,000 2,500 2,000
Retained profits 2,000 1,100 1,000
Liabilities 1,000 1,000 500

7,000 4,600 1,500

H acquired its 80% investment in S on 1 January 20X7.

S acquired its 60% investment in T on 31 December 20X7.
H measures NCI on acquistion at its fair value.
At the dates of the share purchases, the following information is available:
Retained profits Retained profits
of S of T
Date (Rs. 000) (Rs. 000)
1 January 20X7 400 200
31 December 20X7 700 320
Fair value Fair value
of NCI of S of NCI of T
Date (Rs. 000) (Rs. 000)
1 January 20X7 800 1,600
31 December 20X7 960 2,000
Required
Prepare the consolidated statement of financial position for the H Group as at 31 December
20X8.

© Emile Woolf International 70 The Institute of Chartered Accountants of Pakistan

 Chapter 4: Complex groups

3 CONSOLIDATION OF MIXED GROUPS

Section overview

 Mixed groups
 Effective interest in mixed groups
 Date of acquisition of the sub-subsidiary in a mixed group
 Direct method consolidation of mixed group

3.1 Mixed groups

In a mixed group, the parent has both direct and indirect interests in the sub-subsidiary. The
following illustration was shown earlier in section 1 of this chapter. It is repeated here for your
convenience.

Illustration: Mixed group

H Ltd owns 60% of S Ltd and 40% of T Ltd

S Ltd owns 20% of T Ltd.
S Ltd is a subsidiary of H Ltd.
T Ltd is also a subsidiary of H Ltd as it directly owns 40% of T
Ltd. and has an indirect holding through S Ltd. (i-e. 20% x
60%, therefore, its indirect effective interest is 12%), hence, H
Ltd. total interest in T Ltd. is 52%.

3.2 Effective interest in mixed groups

In the above example of a mixed group, H has two interests in T:
 It has a direct interest in T, with the shares that it owns in T.
 It also has an indirect interest in T, through its control of S, which also owns shares in T.
The group interest in the sub-subsidiary T is the sum of the direct interest and the indirect interest
in T as follows:

Illustration: Mixed group – Effective interest in sub-subsidiary

H’s direct holding in T 40%

H’s indirect holding in T (60%  20%) 12%
H’s effective holding in T 52%
Non-controlling interest in T (balance) 48%
100%

© Emile Woolf International 71 The Institute of Chartered Accountants of Pakistan

Advanced accounting and financial reporting

3.3 Date of acquisition of the sub-subsidiary in a mixed group

The same rules apply to mixed groups as they do to vertical groups.

Illustration: Date of acquisition – Situation 1

Commentary
H obtains control of S on 1 May 20X1.
H obtains control of T on 1 May 20X3 when S acquires its stake in T.
From 1 May 20X2 to 1 May 20X3, T is an associate of H.
From 1 May 20X3 onwards T is a subsidiary of H and H has an effective holding of
66% (30% + (80% × 45%)) in T.

Illustration: Date of acquisition – Situation 2

Commentary
H achieves significant influence over T on 1 May 20X2.
H obtains control of S on 1 May 20X4. Thus H also obtains control of T. due to
gaining indirect control over S’s holding in T.
From 1 May 20X2 to 1 May 20X4, T is an associate of H.
From 1 May 20X4 onwards T is a subsidiary of H.

The above illustrations show that there is a further complication that must be taken into account
when consolidating mixed groups. If H’s direct and indirect interests in the sub-subsidiary arise on
different dates the step acquisition rules apply.

© Emile Woolf International 72 The Institute of Chartered Accountants of Pakistan

 Chapter 4: Complex groups

3.4 Direct method consolidation of mixed group

Example: Consolidation of a mixed group

The statements of financial position H, S and T as at 31 December 20X7 were as follows:
H S T
(Rs. 000) (Rs.000) (Rs.000)
Assets:

Investment in S 5,000
Investment in T 1,000 1,750
Other assets 11,900 9,000 2,400
17,900 10,750 2,400
Equity
Share capital 10,000 3,000 300
Retained profits 5,900 4,750 1,600
Liabilities 2,000 3,000 500
17,900 10,750 2,400

H acquired its 80% investment in S on 1 June 20X1.

H acquired its 10% investment in S on 15 October 20X2.
S acquired its 45% investment in T on 1 May 20X3.
The following information is available:
Retained Retained
profits of S profits of T
Date Rs. 000 Rs. 000
1 June 20X1 2,000 500
15 October 20X2 2,300 650
1 May 20X3 3,000 800
The fair value of H’s 10% holding in T was Rs. 1,500,000 on 1 May 20X3.
Required
Prepare the consolidated statement of financial position for the H Group as at 31 December
20X7.

H Group: Consolidated statement of financial position at 31 December 20X7:

Rs. 000
Assets
Goodwill (W3) 3,394
Other assets (11,900 + 9,000 + 2,400) 23,300
Total assets 26,694
Equity
Share capital 10,000
Consolidated retained profits (W5) 8,968
18,968
Non-controlling interest (W2) 2,226
21,194
Liabilities (2,000 + 3,000 + 500) 5,500
Total equity and liabilities 26,694

© Emile Woolf International 73 The Institute of Chartered Accountants of Pakistan

Advanced accounting and financial reporting

Example: (continued)
Workings
W1: Group structure

T became a subsidiary of H on 1 May 20X3 when S bought its interest in T.

H’s effective holding in T

Direct holding 10%
Indirect holding (80%  45%) 36%
Effective holding 46%
Non-controlling interest (balance) 54%
100%

W2a: Net assets summary of S

At date of At date of Post-
consolidation acquisition acquisition
Share capital 3,000 3,000
Retained profits 4,750 2,000 2,750
Net assets 7,750 5,000

W2b: Net assets summary of T

At date of At date of Post-
consolidation acquisition acquisition
Share capital 300 300
Retained profits 1,600 800 800
Net assets 1,900 1,100

W3: Goodwill Rs. 000

On acquisition of S
Cost of investment 5,000
Share of net assets at acquisition (5,000 x 80%) (4,000)
1,000

© Emile Woolf International 74 The Institute of Chartered Accountants of Pakistan

 Chapter 4: Complex groups

Example: (continued)
On acquisition of T Rs. 000
Direct holding
Cost of direct holding 1,000
Fair value adjustment 500
Fair value of first purchase (given) 1,500
Indirect holding
Cost of investment (80%  1,750) 1,400
Total cost of control 2,900
Share of Net assets at acquisition (1,100 x 46%) (506)
2,394
Total goodwill 3,394

W4: Non-controlling interest

NCI in S
NCI’s share of net assets of at the date of acquisition
(20%  5,000 (W2a)) 1,000
NCI’s share of the post-acquisition retained profits of S
(20% of 2,750 (W2a)) 550
NCI’s share of net assets at the date of consolidation 1,550
NCI in T
NCI’s share of net assets of at the date of acquisition
(54%  1,100(W2b)) 594
NCI’s share of the post-acquisition retained profits of S
(54% of 800 (W2b)) 432
NCI’s share of net assets at the date of consolidation 1,026
Less NCI in S share of cost of investment in T (20%  1,750) (350)
676
Total NCI 2,226

W5: Consolidated retained profits:

All of H’s retained profits 5,900
Revaluation of first investment in T 500
6,400
H’s share of the post-acquisition retained profits of S
(80% of 2,750 (W2a)) 2,200
H’s share of the post-acquisition retained profits of T
(46% of 800 (W2b)) 368
8,968

© Emile Woolf International 75 The Institute of Chartered Accountants of Pakistan

Advanced accounting and financial reporting

4 OTHER ISSUES
Section overview

 Accounting for sub-associates

 Consolidated statements of profit or loss when there are sub-subsidiaries

4.1 Accounting for sub-associates

An associate is an entity over which an investor has significant influence.
Sub-subsidiaries may be consolidated either using the indirect (2 step) method or the direct (1
step) method.
There is no such choice in accounting for interests in sub-associates. They must be accounted for
using two step approach.
 Step 1: The investment is equity accounted into the financial statements of the main
subsidiary.
 Step 2: The revised financial statements of the main subsidiary are then consolidated with
those of the parent. The main subsidiary’s non-controlling interest will share in the equity
accounted associate in the usual way.
There is no concept of effective holding when accounting for investments in sub-associates.
This is because when a member of a group has a holding that gives it significant influence over
another entity, that entity is not a member but an associate of the group. As such it must be equity
accounted into the group accounts based on the group’s share of the movement in its net assets
since the date of acquisition.

Example: Consolidation where there is a sub-associate

H Ltd acquired 75% of S Ltd on 1 January 20X4 when the retained profits of S were Rs. 40,000.
S Ltd acquired 20% of T Ltd on 30 June 20X4 when the retained profits of T Ltd were Rs. 25,000.
They had been Rs. 20,000 on the date of H Ltd’s acquisition of S Ltd.
Draft statements of financial position of H Ltd, S Ltd and T Ltd, as at 31 December 20X4, are as
follows:

H Ltd S Ltd T Ltd

Rs. ’000 Rs. ’000 Rs. ’000
Other assets 280 110 100
Investment in S 120
Investment in T 80
400 190 100

Share capital 200 100 50

Retained profits 100 60 30
Liabilities 100 30 20
400 190 100

© Emile Woolf International 76 The Institute of Chartered Accountants of Pakistan

 Chapter 4: Complex groups

Example (continued): Consolidation where there is a sub-associate

A consolidated statement of financial position as at 31 December 20X1 can be prepared as

follows:
H Group: Consolidated statement of financial position at 31 December 20X1
Rs.
Assets
Goodwill (see working) 15
Investment in associate 81
Other assets 390
Total assets 486
Equity
Share capital 200.00
Consolidated retained profits (see working) 115.75
315.75
Non-controlling interest (see working) 40.25
356.00
Current liabilities 130.00
Total equity and liabilities 486.00

Step 1: Equity account T into S

Net assets summary of T
At date of At date of Post-
consolidation acquisition acquisition
Share capital 50 50
Retained profits 30 25 5
Net assets 80 75

In S’s books Dr Cr
Cost of investment 1
Statement of profit or loss (retained profits)
(20%  5) 1

S’s balances change as follows: Investment in S Retained

profits
Per question 80 60
Share of post-acquisition profits 1 1
81 61

© Emile Woolf International 77 The Institute of Chartered Accountants of Pakistan

Advanced accounting and financial reporting

Example (continued): Consolidation where there is a sub-associate

Step 2: Consolidate S into H

Net assets summary of S
At date of At date of Post-
consolidation acquisition acquisition
Share capital 100 100
Retained profits 61 40 21
Net assets 161 140

Goodwill on acquisition of S Rs.

Cost of investment 120
Non-controlling interest at acquisition (25%  140) 35
155
Net assets at acquisition (see above) (140)
15

Non-controlling interest Rs.

NCI in S
NCI’s share of net assets of at the date of acquisition
(25%  140) 35.00
NCI’s share of the post-acquisition retained profits of S (25%
of 21 (see above)) 5.25
NCI’s share of net assets at the date of consolidation 40.25

Consolidated retained profits: Rs.

All of H’s retained profits 100.00
H’s share of the post-acquisition retained profits of S (75%
of 21 (see above)) 15.75
115.75

4.2 Consolidated statements of profit or loss when there are sub-subsidiaries

Consolidation of statements of profit or loss involving sub-subsidiaries and sub-associates is
carried out as normal. The effective rate may be used to consolidate sub-subsidiaries and sub-
associates are accounted for under equity method using a two stage process.
There is one possible complication when consolidating sub-subsidiaries.
 If the sub-subsidiary has paid a dividend and the main subsidiary has accounted for its share
through the profit and loss account this will be part of the subsidiary’s profit before tax.
 It must be eliminated (as a consolidation adjustment) during the non-controlling interest
calculation.

© Emile Woolf International 78 The Institute of Chartered Accountants of Pakistan

 Chapter 4: Complex groups

Example: Consolidated statement of profit or loss with a sub-subsidiary

H owns 80% of S which owns 60% of T.
H’s effective holding in T is 48% (80%  60%) and the NCI in T is 52%.
T has paid a dividend of Rs. 200 and S has duly accounted for its share (Rs. 120 = 60% of Rs. 200)
as follows

H S T CP&L

Operating profit 1,200 600 500 2,300

Dividend receivable from T  120*  

1,200 720 500 2,300

Taxation (400) (250) (100) (750)

PAT 800 470 400 1,550

Total comprehensive income attributable to:

Owners of the parent (balancing figure) 1,272

Non-controlling interests (working) 278

1,550

Working: Non-controlling interest

In S (20%  (470  120) 70

In T (52%  400) 208

278

© Emile Woolf International 79 The Institute of Chartered Accountants of Pakistan

Advanced accounting and financial reporting

SOLUTIONS TO PRACTICE QUESTIONS

Solution 1
H Group: Consolidated statement of financial position at 31 December 20X4
Rs.
Assets
Goodwill (W2) 904
Other assets (11,900 + 6,000 + 1,500) 19,400
Total assets 20,304
Equity
Share capital 10,000
Consolidated retained profits (W4) 5,284
15,284
Non-controlling interest (W3) 1,520
16,804
Current liabilities (2,000 + 1,000 + 500) 3,500
Total equity and liabilities 20,304
W1: Group structure

S acquired its interest in T before H purchased its interest in S.

Therefore, both S and T entered the H group on 1 January 20X7.

H’s effective holding in T (80%  60%) 48%

Non-controlling interest (balance) 52%
100%

W1a: Net assets summary of S

At date of At date of Post-

consolidation acquisition acquisition
Share capital 3,000 3,000
Retained profits 2,750 2,300 450
Net assets 5,750 5,300

W1b: Net assets summary of T

At date of At date of Post-
consolidation acquisition acquisition
Share capital 300 300
Retained profits 700 650 50
Net assets 1,000 950

© Emile Woolf International 80 The Institute of Chartered Accountants of Pakistan

 Chapter 4: Complex groups

Solution (continued) 1
W2: Goodwill Rs.
On acquisition of S
Cost of investment 5,000
Non-controlling interest at acquisition (20%  5,300 (W1a)) 1,060
6,060
Net assets at acquisition (see above) (5,300)
760
On acquisition of T
Cost of investment (80%  750) 600
Non-controlling interest at acquisition (52%  950 (W1b)) 494
1,094
Net assets at acquisition (see above) (950)
144
Total goodwill 904

W3: Non-controlling interest

NCI in S
NCI’s share of net assets at the date of acquisition
(20%  5,300 (W1a)) 1,060
NCI’s share of the post-acquisition retained profits of S
(20% of 450 (W1a)) 90
NCI’s share of net assets at the date of consolidation 1,150
NCI in T
NCI’s share of net assets at the date of acquisition
(52%  950 (W1b)) 494
NCI’s share of the post-acquisition retained profits of S
(52% of 50 (W1b)) 26
NCI’s share of net assets at the date of consolidation 520
Less NCI in S share of cost of investment in T (20%  750) (150)
370
Total NCI 1,520

W4: Consolidated retained profits:

All of H’s retained profits 4,900
H’s share of the post-acquisition retained profits of S
(80% of 450 (W1a)) 360
H’s share of the post-acquisition retained profits of T
(48% of 50 (W1b)) 24
5,284

© Emile Woolf International 81 The Institute of Chartered Accountants of Pakistan

Advanced accounting and financial reporting

Solution 2
H Group: Consolidated statement of financial position at 31 December 20X4
Rs. 000
Assets
Goodwill (W2) 2,640
Other assets (3,700 + 2,400 + 3,500) 9,600
Total assets 12,240
Equity
Share capital 4,000
Consolidated retained profits (W4) 2,886
6,886
Non-controlling interest (W3) 2,854
9,740
Current liabilities (1,000 + 1,000 + 500) 2,500
Total equity and liabilities 12,240

W1: Group structure

S acquired its interest in T after H purchased its interest in S.

Therefore, the date of acquisition of S is 1 January 20X7 and the date of acquisition of T is 31
December 20X7

H’s effective holding in T (80%  60%) 48%

Non-controlling interest (balance) 52%
100%

W1a: Net assets summary of S

At date of At date of Post-

consolidation acquisition acquisition
Share capital 2,500 2,500
Retained profits 1,100 400 700
Net assets 3,600 2,900

W1b: Net assets summary of T

At date of At date of Post-
consolidation acquisition acquisition
Share capital 2,000 2,000
Retained profits 1,000 320 680
Net assets 3,000 2,320

© Emile Woolf International 82 The Institute of Chartered Accountants of Pakistan

 Chapter 4: Complex groups

Solution (continued) 2
W2: Goodwill Rs. 000
On acquisition of S
Cost of investment 3,300
Non-controlling interest at acquisition(fair value) 800
4,100
Net assets at acquisition (see above) (2,900)
1,200
On acquisition of T
Cost of investment (80%  2,200) 1,760
Non-controlling interest at acquisition (fair value) 2,000
3,760
Net assets at acquisition (see above) (2,320)
1,440
Total goodwill 2,640

W3: Non-controlling interest

NCI in S
Fair value of NCI at the date of acquisition 800
NCI’s share of the post-acquisition retained profits of S
(20% of 700 (W1a)) 140
NCI at the date of consolidation 940
NCI in T
Fair value of NCI at the date of acquisition 2,000
NCI’s share of the post-acquisition retained profits of S
(52% of 680 (W1b)) 354
NCI at the date of consolidation 2,354
Less NCI in S share of cost of investment in T (20%  2,200) (440)
1,914
2,854

W4: Consolidated retained profits:

All of H’s retained profits 2,000
H’s share of the post-acquisition retained profits of S
(80% of 700 (W1a)) 560
H’s share of the post-acquisition retained profits of T
(48% of 680 (W1b)) 326
2,886

© Emile Woolf International 83 The Institute of Chartered Accountants of Pakistan

Advanced accounting and financial reporting

© Emile Woolf International 84 The Institute of Chartered Accountants of Pakistan

 Certified Finance and Accounting Professional

CHAPTER
Advanced accounting and financial reporting

Associates and joint ventures

Contents
1 IFRS 11: Joint arrangements
2 IAS 28: Investments in associates and joint ventures

© Emile Woolf International 85 The Institute of Chartered Accountants of Pakistan

Advanced accounting and financial reporting

1 IFRS 11: JOINT ARRANGEMENTS

Section overview

 Introduction
 Joint arrangements
 Types of joint arrangements
 Accounting for joint operations and joint ventures

1.1 Introduction
Joint Arrangement is a broader term, to make it easy to understand, whenever an entity invests
strategically in an entity, it results in:
 Control of the entity under IFRS 10;
 Joint control under IFRS 11;
 Significant influence under IAS 28; or
 Financial instruments under IFRS 9;
When it is a subsidiary (and given that parent is not a subsidiary of ultimate parent), it is
consolidated. It has been discussed in detail in Chapter 1 to 4.
When it is a significant influence or joint control, it either categorized at cost or using Equity Method.
This has been discussed in detail in this Chapter.
When an investment neither results in control nor a significant influence or joint control (this has
been discussed in detail in Chapter 9), such an interest in the equity shares of another company
that gives no influence is accounted for as follows:
 The shares are shown in the statement of financial position as long-term assets (an
investment) and valued in accordance with IFRS 9; and
 Any dividends received for the shares are included in profit or loss for the year as other
income.
Other investments might result in joint control or significant influence. The rules for accounting for
these are given in:
 IFRS 11 Joint Arrangements: and
 IAS 28 Investments in Associates and Joint ventures.
This session introduces the rules on accounting for joint arrangements.

1.2 Joint arrangements

Definition
A joint arrangement is an arrangement of which two or more parties have joint control.
Joint control is the contractually agreed sharing of control of an arrangement, which exists only
when decisions about the relevant activities require the unanimous consent of the parties sharing
control.

A joint arrangement has the following characteristics:

 The parties are bound by a contractual arrangement; and
 The contractual arrangement gives two or more of those parties joint control of the
arrangement.
Definition
A party to a joint arrangement is an entity that participates in a joint arrangement, regardless of
whether that entity has joint control of the arrangement.

© Emile Woolf International 86 The Institute of Chartered Accountants of Pakistan

 Chapter 5: Associates and joint ventures

Contractual arrangement
Any contractual arrangement will usually be evidenced in writing, usually in the form of a contract
or documented discussions between the parties.
A joint arrangement might be structured through a separate vehicle in which case some aspects
of the contractual arrangement might be incorporated in its articles, charter or by-laws.
Any contractual arrangement sets out the terms upon which the parties participate in the activity
that is the subject of the arrangement and would generally deal with such matters as:
 the purpose, activity and duration of the joint arrangement;
 how the members of the board of directors, or equivalent governing body, of the joint
arrangement, are appointed;
 the decision-making process (the matters requiring decisions from the parties, the voting
rights of the parties and the required level of support for those matters).
 the capital or other contributions required of the parties.
 how the parties share assets, liabilities, revenues, expenses or profit or loss relating to the
joint arrangement.
Joint control
IFRS 11 states that decisions about the relevant activities require unanimous consent of all parties
that collectively control the arrangement. It is not necessary for every party to the arrangement to
agree in order for unanimous consent to exist. This requires agreement by only those parties that
collectively control the arrangement.
Day to day decision making might be delegated to a manager or to one of the parties to the
arrangement. In such cases, the situation would need to be analysed to decide whether, in fact,
decisions require the unanimous agreement of the interested parties. Such an arrangement is still
a joint arrangement when the manager executes the policy decisions that have been agreed
unanimously by the investors.

Example: Joint control

In each of the following scenarios three entities A, B and C establish an arrangement.

Scenario 1 Scenario 2 Scenario 3

Decisions about Require the unanimous Require at least Require at least
relevant activities consent of A, B and C 75% of voting rights 75% of voting rights
Ownership interest
A 50% 50% 50%
B 30% 30% 25%
C 20% 20% 25%
Required
For each scenario analyse whether a joint arrangement exists and which parties have joint control.

Answer
Scenario 1
A, B and C have joint control of the arrangement and each must account for its investment
according to IFRS 11.
Scenario 2
Although A can block any decision, it does not control the arrangement because it needs the
agreement of B.

© Emile Woolf International 87 The Institute of Chartered Accountants of Pakistan

Advanced accounting and financial reporting

A and B have joint control of the arrangement. The terms of their contractual arrangement requiring
at least 75% of the voting rights to make decisions about the relevant activities imply that A and B
have joint control of the arrangement because decisions about the relevant activities of the
arrangement cannot be made without both A and B agreeing.
A and B must each account for its investment according to IFRS 11.
C is a party to a joint arrangement but has no control.
Scenario 3
The arrangement can be controlled by A with B or by A with C. This means that no party can be said
to have joint control.
In order for this to be a joint arrangement the contractual terms would have to specify which
combination of parties is required to agree about the relevant activities.
IFRS 11 does not apply to this investment.

1.3 Types of joint arrangements

There are two types of joint arrangement. A joint arrangement is either a joint operation or a joint
venture.
Definition
A joint operation is a joint arrangement whereby the parties that have joint control of the
arrangement have rights to the assets, and obligations for the liabilities, relating to the
arrangement. Those parties are called joint operators.
A joint venture is a joint arrangement where the parties that have joint control of the arrangement
have rights to the net assets of the arrangement. Those parties are called joint venturers.

This classification depends on the rights and obligations of the parties to the arrangement.
Investors may or may not establish a joint arrangement as a separate vehicle.
Definition
A separate vehicle is a separately identifiable financial structure, including separate legal entities
or entities recognised by statute, regardless of whether those entities have a legal personality.

The application guidance to IFRS 11 says that if a joint arrangement is not structured through a
separate vehicle it must be a joint operation.
If a joint arrangement is structured through a separate vehicle it could be a joint operation or a joint
venture.
For a joint arrangement to be a joint venture it is the separate vehicle that must have the rights to
the assets and the obligations to the liabilities with the investor only having an interest in the net
assets of the entity. If an investor has a direct interest in specific assets and direct obligation for
specific liabilities of the separate vehicle then the joint arrangement is a joint operation.

1.4 Accounting for joint operations and joint ventures

The method of accounting for an interest in a joint arrangement depends on what type of joint
arrangement it is.

Joint operations
A joint operator must recognise the following in its own financial statements:
 its assets, including its share of any assets held jointly;
 its liabilities, including its share of any liabilities incurred jointly;
 its revenue from the sale of its share of the output arising from the joint operation;
 its share of the revenue from the sale of the output by the joint operation; and
 its expenses, including its share of any expenses incurred jointly.

© Emile Woolf International 88 The Institute of Chartered Accountants of Pakistan

 Chapter 5: Associates and joint ventures

Joint ventures
A joint venturer must recognise its interest in a joint venture as an investment and account for it
using the equity method in accordance with IAS 28 Investments in Associates and Joint Ventures
unless the entity is exempted from applying the equity method as specified in that standard.
If an entity participates in, but does not have joint control of a joint operation it must account for its
interest in the arrangement in accordance with IFRS 9 Financial Instruments, unless it has
significant influence over the joint venture, in which case it must account for it in accordance with
IAS 28.

Example – Accounting for a joint operation

On 1 January 20X7, X and Y entered into a joint operation to purchase and operate an oil pipeline.
Both entities contributed equally to the purchase cost of Rs.20 million and this was financed by a
joint loan of Rs.20,000,000.
Contract terms
Y carries out all maintenance work on the pipeline but maintenance expenses are shared between
X and Y in the ratio 40%: 60%.
Both entities use the pipeline for their own operations and share any income from third parties
50%: 50%. Sales to third parties are invoiced by Y.
The full interest on the loan is initially paid by X but the expense is to be shared equally.
During the year ended 31 December 20X7
Y carried out maintenance at a cost of Rs. 1,200,000.
Income from third parties was Rs. 900,000, all paid to Y.
Interest of Rs. 1,500,000 was paid for the year on 31 December by X.
Required
Show the relevant figures that would be recognised in the financial statements of X and Y for the
year to 31 December 20X7.

Answer
Total In X financial In Y financial
amount statements statements
Statement of financial position Rs. Rs. Rs.
Jointly-controlled assets
Property, plant and equipment
Cost 20,000,000 10,000,000 10,000,000

Share of liabilities incurred

Bank loan 20,000,000 10,000,000 10,000,000
Current: account with Y (owed by Y)
– see workings 720,000
Current: account with X (owed to X)
– see workings 720,000
Share of revenue
Income from third parties (50:50) 900,000 450,000 450,000
Share of expenses
Maintenance costs (40:60) 1,200,000 480,000 720,000
Interest on loan (50:50) 1,500,000 750,000 750,000
2,700,000 1,230,000 1,470,000

© Emile Woolf International 89 The Institute of Chartered Accountants of Pakistan

Advanced accounting and financial reporting

Workings

Statement of profit or loss

Income from third parties (50:50) 900,000 450,000 450,000

Maintenance costs (40:60) 1,200,000 480,000 720,000

Interest on loan (50:50) 1,500,000 750,000 750,000

(2,700,000) (1,230,000) (1,470.000)

(1,800,000) (780,000) (1,020.000)

Cash expense (1,500,000) (1,200,000)

Cash collected 900,000

Net cash expense (1,500,000) (300,000)

Cash due to X from Y 720,000 (720,000)

© Emile Woolf International 90 The Institute of Chartered Accountants of Pakistan

 Chapter 5: Associates and joint ventures

2 IAS 28: INVESTMENTS IN ASSOCIATES AND JOINT VENTURES

Section overview

 Associates and joint ventures

 Accounting for associates and joint ventures
 Trading with an associate or joint venture

2.1 Associates and joint ventures

Definition
An associate is an entity over which the investor has significant influence.

Significant influence

Significant influence is the power to participate in the financial and operating policy decisions of
the investee but is not control or joint control of those policies.

 IAS 28 states that if an entity holds 20% or more of the voting power (equity) of another
entity, it is presumed that significant influence exists, and the investment should be treated
as an associate.

 If an entity owns less than 20% of the equity of another entity, the normal presumption is
that significant influence does not exist.
Holding 20% to 50% of the equity of another entity therefore means as a general rule that significant
influence exists, but not control; therefore, the investment is treated as an associate, provided that
it is not a joint venture.
The ‘20% or more’ rule is a general guideline, however, and IAS 28 states more specifically how
significant influence arises. The existence of significant influence is usually evidenced in one or
more of the following ways:

 Representation on the board of directors;

 Participation in policy-making processes, including participation in decisions about

distributions (dividends);

 Material transactions between the two entities;

 An interchange of management personnel between the two entities; or

 The provision of essential technical information by one entity to the other.

2.2 Accounting for associates and joint ventures

IAS 28 states that associates and joint ventures must be accounted for using the equity method.
The equity method is defined as a method of accounting whereby the investment is initially
recognised at cost and adjusted thereafter for the post-acquisition change in the investor’s share
of the investee’s net assets.
The investor’s profit or loss includes its share of the investee’s profit or loss and the investor’s other
comprehensive income includes its share of the investee’s other comprehensive income.

© Emile Woolf International 91 The Institute of Chartered Accountants of Pakistan

Advanced accounting and financial reporting

Statement of financial position: investment in the associate

In the statement of financial position of the reporting entity (the investor), an investment in an
associate is measured at:

Illustration: Equity method

Rs.

Cost of investment X

Plus/(Minus): Parent’s share of profits (losses) of the associate (or JV)

since acquisition X

Plus/(Minus): Parent’s share of OCI of the associate (or JV) since

acquisition X

Minus any impairment of the investment recognised (X)

There is no goodwill-recognised for an investment in an associate.

The accumulated profits of the reporting entity (or the consolidated accumulated reserves when
consolidated accounts are prepared) should include the investor’s share of the post-acquisition
retained profits of the associate (or JV), (minus any impairment in the value of the investment
since acquisition). This completes the other side of the entry when the investment is remeasured.
Similarly, any other reserve of the reporting entity (or any other consolidated reserves when
consolidated accounts are prepared) should include the investor’s share of the post-acquisition
movement in the reserve of the associate (or JV).
Statement of profit or loss and other comprehensive income
In the statement of profit or loss and other comprehensive income, there should be separate lines
for:
 ‘Share of profits of associate (or JV)’ in the profit and loss section of the statement
 ‘Share of other comprehensive income of associate (or JV)’ in the ‘other comprehensive
income’ section of the statement.

Example: Equity method

Entity P acquired 30% of the equity shares in Entity A during Year 1 at a cost of Rs. 147,000
when the fair value of the net assets of Entity A was Rs. 350,000.
Entity P is able to exercise significant influence over Entity A.
At 31 December Year 5, the net assets of Entity A were Rs. 600,000.
In the year to 31 December Year 5, the profits of Entity A after tax were Rs. 80,000.
The figures that must be included to account for the associate in the financial statements of
Entity P for the year to 31 December Year 5 are as follows:

Statement of financial position:

The investment in the associate is as follows: Rs.
Investment at cost 147,000
Investor’s share of post-acquisition profits of A (W1) 75,000
Investment in the associate 222,000

© Emile Woolf International 92 The Institute of Chartered Accountants of Pakistan

 Chapter 5: Associates and joint ventures

Example: Equity method (continued)

W1 Retained post-acquisition profits of Entity A Rs.
Net assets of the associate at 31 December Year 5 600,000
Net assets of Entity A at date of acquisition of shares (350,000)
Retained post-acquisition profits of Entity A 250,000
Entity P’s share of A 30%
Entity P’s share of A’s profits since the date of acquisition Rs.75,000

Note: Rs.75,000 will be included in the accumulated profits of Entity P

The journal to achieve the re-measurement is
Dr Cost Rs.75,000 and Cr Accumulated profits Rs.75,000

Statement of profit or loss

The share of the associate’s after-tax profit for the year is shown on a separate line as:
Share of profits of associate (30% × Rs. 80,000): Rs. 24,000.

Practice question 1
Entity P acquired 40% of the equity shares in Entity A during Year 1 at a cost of Rs.
128,000 when the fair value of the net assets of Entity A was Rs. 250,000.
Since that time, the investment in the associate has been impaired by Rs. 8,000.
Since acquisition of the investment, there has been no change in the issued share capital
of Entity A, nor in its share premium reserve or revaluation reserve.
On 31 December Year 5, the net assets of Entity A were Rs. 400,000.
In the year to 31 December Year 5, the profits of Entity A after tax were Rs. 50,000.
What figures would be included for the associate in the financial statements of Entity P
for the year to 31 December Year 5?

When an investment in an associate or a joint venture is held by, or is held indirectly through, an
entity that is;
 a venture capital organisation, or
 a mutual fund, unit trust and similar entities including investment-linked insurance funds,
the entity may elect to measure that investment at fair value through profit or loss in accordance
with IFRS 9. An entity shall make this election separately for each associate or joint venture, at
initial recognition of the associate or joint venture.
When an entity has an investment in an associate, a portion of which is held indirectly through;
 a venture capital organisation, or
 a mutual fund, unit trust and similar entities including investment-linked insurance funds,
the entity may elect to measure that portion of the investment in the associate at fair value through
profit or loss in accordance with IFRS 9 regardless of whether it has significant influence over that
portion of the investment.
If the entity makes that election, the entity shall apply the equity method to any remaining portion
of its investment in an associate that is not held through a venture capital organisation, or a mutual
fund, unit trust and similar entities including investment-linked insurance funds.

© Emile Woolf International 93 The Institute of Chartered Accountants of Pakistan

Advanced accounting and financial reporting

2.3 Trading with an associate or joint venture

There might be trading between a parent and an associate (or JV). If in addition to the associate
(or JV) the parent holds investments in subsidiaries there might also be trading between other
members of the group and the associate (or JV).
In such cases there might be:
 Inter-company balances (amounts owed between the parent (or group) and the associate
(or JV) in either direction); and
 Unrealised profit on inter-company transactions.
The accounting rules for dealing with these items for associate (or JVs) are different from the rules
for subsidiaries.
Inter-company balances
Inter-company balances between the members of a group (parent and subsidiaries) are cancelled
out on consolidation.
Inter-company balances between the members of a group (parent and subsidiaries) and associates
(or JVs) are not cancelled out on consolidation. An associate (or JV) is not a member of the group
but is rather an investment made by the group. This means that it is entirely appropriate that
consolidated financial statements show amounts owed by the external party as an asset and
amount owed to the external party as a liability.
This is also the case if a parent has an associate (or JV) and no subsidiaries. The parent must
account for the investment under equity method. Once again, it is entirely appropriate that
consolidated financial statements show amounts owed by the external party as an asset and
amount owed to the external party as a liability.
Unrealised inter-group profit
Unrealised inter-company (intra-group) profit between a parent and a member of a group must be
eliminated in full on consolidation.
For unrealised profit arising on trade between a parent and associate (or JV) only the parent’s
share of the unrealised profit is eliminated.
IAS 28 does not specify the double entry to achieve this.
The following are often used in practice
Parent sells to associate (or JV):
 The unrealised profit is held in inventory of the associate (or JV). The investment in the
associate (or JV) should be reduced by the parent’s share of the unrealised profit.
 The other side of the entry increases cost of sales

Illustration: Unrealised profit double entry when parent sells to associate Debit Credit
Cost of sales X
Investment in associate X

Associate (or JV) sells to parent:

 The unrealised profit is held in inventory of the parent and this should be reduced in value
by the parent’s share of the unrealised profit.
 The other side of the entry reduces the parent’s share of the profit of the associate (or JV).

Illustration: Unrealised profit double entry when associate sells to parent Debit Credit
Share of profit of associate X
Inventory X

In both cases, there will also be a reduction in the post-acquisition profits of the associate (or JV),
and the investor entity’s share of those profits (as reported in profit or loss). This will reduce the
accumulated profits in the statement of financial position.

© Emile Woolf International 94 The Institute of Chartered Accountants of Pakistan

 Chapter 5: Associates and joint ventures

Example: Unrealised profit

Entity P acquired 40% of the equity shares of Entity A several years ago. The cost of the investment
was Rs. 205,000.
As at 31 December Year 6 Entity A had made profits of Rs. 275,000 since the date of acquisition.
In the year to 31 December Year 6, Entity P sold goods to Entity A at a sales price of Rs. 200,000
at a mark-up of 100% on cost.
Goods which had cost Entity A Rs. 30,000 were still held as inventory by Entity A at the year-end.
The necessary adjustments for unrealised profit, and the double entries are as follows:
Unrealised profit adjustment Rs.
Inventory sold by P to A 200,000
Profit on the sale (200,000  100%/200%) 100,000
Unrealised profit (100,000  Rs.30,000/Rs.200,000) 15,000
Entity P’s share (40%) 6,000

Double entries: Dr (Rs.) Cr (Rs.)

Investment in associate 110,000
Accumulated profits 110,000
Being: Share of post-acquisition profits (40% of Rs.275,000)

Dr (Rs.) Cr (Rs.)
Cost of sales (hence accumulated profit) 6,000
Investment in associate 6,000
Being: Elimination of share of unrealised profit (see above)

Investment in associate (see above for adjustments) Rs.

Cost of the investment 205,000
Entity P’s share of post-acquisition profits of Entity A 110,000
Minus: Entity P’s share of unrealised profit in inventory (6,000)
309,000

Practice question 2
Entity P acquired 30% of the equity shares of Entity A several years ago at a cost of Rs.
275,000.
As at 31 December Year 6 Entity A had made profits of Rs. 380,000 since the date of
acquisition.
In the year to 31 December Year 6, the reported profits after tax of Entity A were Rs.
100,000.
In the year to 31 December Year 6, Entity P sold goods to Entity A for Rs. 180,000 at a
mark-up of 20% on cost.
Goods which had cost Entity A Rs. 60,000 were still held as inventory by Entity A at the
year-end.
a) Calculate the unrealised profit adjustment and state the double entry.
b) Calculate the investment in associate balance that would be included in Entity P’s
statement of fiancial position as at 31 December Year 6.
c) Calculate the amount that would appear as a share of profit of associate in Entity P’s
statement of profit or loss for the year ending 31 December Year 6.

© Emile Woolf International 95 The Institute of Chartered Accountants of Pakistan

Advanced accounting and financial reporting

SOLUTIONS TO PRACTICE QUESTIONS

Solution 1
The figures that must be included to account for the associate in the financial statements of Entity P for
the year to 31 December Year 5 are as follows:
Statement of financial position:
The investment in the associate is as follows:
Rs.
Investment at cost 128,000
Investor’s share of post-acquisition profits of A (W1) 60,000
Minus: Accumulated impairment in the investment (8,000)
Investment in the associate 180,000
W1 Retained post-acquisition profits of Entity A
Net assets of the associate at 31 December Year 5 400,000
Net assets of Entity A at date of acquisition of shares (250,000)
Retained post-acquisition profits of Entity A 150,000
Entity P’s share of A 40%
Entity P’s share of A’s profits since the date of acquisition Rs.60,000
Statement of profit or loss
The share of the associate’s after-tax profit for the year is shown on a separate line as:
Share of profits of associate (40% × Rs. 50,000): Rs. 20,000.

Solution 2
a) Unrealised profit adjustment Rs.
Inventory sold by P to A 180,000
Profit on the sale (180,000  20%/120%) 30,000
Unrealised profit (30,000  Rs.60,000/Rs.180,000) 10,000
Entity P’s share (30%) 3,000

Double entry Dr(Rs.) Cr(Rs.)

Cost of sales (hence accumulated profit) 3,000
Investment in associate 3,000
Being: Elimination of share of unrealised profit (see above)

b) Investment in associate (see above for adjustments) Rs.

Cost of the investment 275,000
Entity P’s share of post-acquisition profits of Entity A (30% of
Rs.380,000) 114,000
Minus: Entity P’s share of unrealised profit in inventory (3,000)
386,000
c) Statement of profit or loss
The share of the associate’s after-tax profit for the year is shown on a separate line as:
Share of profits of associate (30% × Rs. 100,000): Rs.30,000.

© Emile Woolf International 96 The Institute of Chartered Accountants of Pakistan

 Certified Finance and Accounting Professional

CHAPTER
Advanced accounting and financial reporting

Other group standards

Contents
1 IAS 27 Separate financial statements
2 IFRS 12: Disclosure of interests in other entities

© Emile Woolf International 97 The Institute of Chartered Accountants of Pakistan

Advanced accounting and financial reporting

1 IAS 27 SEPARATE FINANCIAL STATEMENTS

Section overview

 Introduction to IAS 27
 Preparation of separate financial statements
 Disclosure

1.1 Introduction to IAS 27

IAS 27 contains accounting and disclosure requirements for investments in subsidiaries, joint
ventures and associates when an entity prepares separate financial statements.
IAS 27 requires an entity preparing separate financial statements to account for those investments
at cost, in accordance with IFRS 9 Financial Instruments or using equity method as described in
IAS 28 Investments in Associates and Joint Ventures.
IAS 27 does not mandate which entities must produce separate financial statements.
Definition
Separate financial statements: Those presented by an entity in which the entity could elect, subject
to the requirements in this standard, to account for its investment in subsidiaries, joint ventures
and associates either at cost, in accordance with IFRS 9 or using equity method as described in IAS
28.
Separate financial statements are those presented in addition to consolidated financial statements
or in addition to financial statements in which investments in associates or joint ventures are
accounted for using the equity method.
However, if a company is exempt from the need to consolidate or account for an investment using
the equity method the separate financial statements are its only financial statements.
1.2 Preparation of separate financial statements
Separate financial statements must be prepared in accordance with all applicable IFRSs.
Investments in subsidiaries, joint ventures and associates must be accounted for in separate
financial statements, either:
 at cost; or
 in accordance with IFRS 9.
 Using equity method as described in IAS 28
A company must apply the same accounting for each category of investments.
Investments accounted for at cost or using the equity method are accounted for in accordance with
IFRS 5 when they are classified as held for sale.
Dividends are recognised in profit or loss in separate financial statements when the right to receive
the dividend is established unless the entity elects to use the equity method in this case the
dividend are recognised as the reduction form the carrying amount of the investment.

1.3 Disclosure
All applicable IFRSs apply when providing disclosures in separate financial statements as well as
the following requirements.
When a parent prepares separate financial statements, it must disclose:
 the fact that the financial statements are separate financial statements; that the exemption
from consolidation has been used; the name and principal place of business (and country of
incorporation, if different) of the entity whose consolidated financial statements that comply
with International Financial Reporting Standards have been produced for public use; and the
address where those consolidated financial statements are obtainable.

© Emile Woolf International 98 The Institute of Chartered Accountants of Pakistan

 Chapter 6: Other group standards

 a list of significant investments in subsidiaries, joint ventures and associates, including:

 the name of those investees.
 the principal place of business (and country of incorporation, if different) of those
investees.
 its proportion of the ownership interest (and its proportion of the voting rights, if
different) held in those investees.
 a description of the method used to account for the investments listed.
When a parent (other than a parent covered by preceding paragraphs or an investor with joint
control of, or significant influence over, an investee prepares separate financial statements, the
parent or investor shall identify the financial statements to which they relate., it must disclose:
 the fact that the financial statements are separate financial statements and the reasons why
those statements are prepared if not required by law.;
 a list of significant investments in subsidiaries, joint ventures and associates, including:
 the name of those investees.
 the principal place of business (and country of incorporation, if different) of those
investees.
 its proportion of the ownership interest (and its proportion of the voting rights, if
different) held in those investees.
 a description of the method used to account for the investments

© Emile Woolf International 99 The Institute of Chartered Accountants of Pakistan

Advanced accounting and financial reporting

2 IFRS 12: DISCLOSURE OF INTERESTS IN OTHER ENTITIES

Section overview

 Introduction to IFRS 12
 Significant judgements and assumptions
 Interests in subsidiaries
 Interests in joint arrangements and associates
 Structured entities

2.1 Introduction to IFRS 12

The objective of IFRS 12 is to require companies to disclose information that enables users of their
financial statements to evaluate:
 the nature of, and risks associated with, its interests in other entities; and
 the effects of those interests on its financial position, financial performance and cash flows.
This requires disclosure of:
 the significant judgements and assumptions it has made in determining the nature of its
interest in another entity or arrangement, and in determining the type of joint arrangement
in which it has an interest; and
 information about its interests in:
 subsidiaries;
 joint arrangements and associate); and
 structured entities that are not controlled by the entity (unconsolidated structured
entities).
IFRS 12 sets out required disclosures but disclosure of additional information might be necessary
to meet IFRS 12’s objective.
IFRS 12 must be applied by a company that has an interest in any of the following:
 subsidiaries;
 joint arrangements (i.e. joint operations or joint ventures);
 associates;
 unconsolidated structured entities.

2.2 Significant judgements and assumptions

A company must disclose information about significant judgements and assumptions it has made
(and changes to those judgements and assumptions) in determining:
 that it has control of another entity;
 that it has joint control of an arrangement or significant influence over another entity; and
 the type of joint arrangement (i.e. joint operation or joint venture) when the arrangement has
been structured through a separate vehicle.
To comply with the above a company must disclose, for example, significant judgements and
assumptions made in determining that:
 it does not control another entity even though it holds more than half of the voting rights of
the other entity;
 it controls another entity even though it holds less than half of the voting rights of the other
entity;

© Emile Woolf International 100 The Institute of Chartered Accountants of Pakistan

 Chapter 6: Other group standards

 it is an agent or a principal;
 it does not have significant influence even though it holds 20% or more of the voting rights
of another entity;
 it has significant influence even though it holds less than 20% of the voting rights of another
entity.

2.3 Interests in subsidiaries

A company must disclose information that enables users of its consolidated financial statements
 to understand:
 the composition of the group; and
 the interest that non-controlling interests have in the group’s activities and cash flows;
and
 to evaluate:
 the nature and extent of significant restrictions on its ability to access or use assets,
and settle liabilities, of the group;
 the nature of, and changes in, the risks associated with its interests in consolidated
structured entities;
 the consequences of changes in its ownership interest in a subsidiary that do not
result in a loss of control; and
 the consequences of losing control of a subsidiary during the reporting period.
When the financial statements of a subsidiary used in the preparation of consolidated financial
statements are as of a date or for a period that is different from that of the consolidated financial
statements, a company must disclose:
 the date of the end of the reporting period of the financial statements of that subsidiary; and
 the reason for using a different date or period.
Non-controlling interests
A company must disclose for each of its subsidiaries that have non-controlling interests that are
material to the reporting entity:
 the name of the subsidiary;
 the principal place of business (and country of incorporation if different) of the subsidiary;
 the proportion of ownership interests held by non-controlling interests;
 the proportion of voting rights held by non-controlling interests, if different from the proportion
of ownership interests held;
 the profit or loss allocated to non-controlling interests of the subsidiary during the reporting
period;
 accumulated non-controlling interests of the subsidiary at the end of the reporting period;
and
 summarised financial information about the subsidiary.
The nature and extent of significant restrictions
A company must disclose:
 any significant restrictions on its ability to access or use the assets and settle the liabilities
of the group, such as:
 those that restrict the ability of a parent or its subsidiaries to transfer cash or other
assets to (or from) other entities within the group;
 guarantees or other requirements that may restrict dividends and other capital
distributions being paid, or loans and advances being made or repaid, to (or from)
other entities within the group; and

© Emile Woolf International 101 The Institute of Chartered Accountants of Pakistan

Advanced accounting and financial reporting

 the nature and extent to which protective rights of non-controlling interests can significantly
restrict the entity’s ability to access or use the assets and settle the liabilities of the group
(such as when a parent is obliged to settle liabilities of a subsidiary before settling its own
liabilities, or approval of non-controlling interests is required either to access the assets or
to settle the liabilities of a subsidiary).
 the carrying amounts in the consolidated financial statements of the assets and liabilities to
which those restrictions apply.
Consequences of losing control of a subsidiary during the reporting period
A company must disclose the gain or loss arising on the loss of control of a subsidiary during the
period together with the line item(s) in profit or loss in which the gain or loss is recognised (if not
presented separately).

2.4 Interests in joint arrangements and associates

A company must disclose information that enables users of its financial statements to evaluate:
 the nature, extent and financial effects of its interests in joint arrangements and associates,
including the nature and effects of its contractual relationship with the other investors with
joint control of, or significant influence over, joint arrangements and associates; and
 the nature of, and changes in, the risks associated with its interests in joint ventures and
associates.
Nature, extent and financial effects of interests in joint arrangements and associates
A company must disclose:
 for each material joint arrangement and associate:
 the name of the joint arrangement or associate.
 the nature of the entity’s relationship with the joint arrangement or associate;
 the principal place of business (and country of incorporation, if applicable and different
from the principal place of business) of the joint arrangement or associate.
 the proportion of ownership interest or participating share held by the entity and, if
different, the proportion of voting rights held (if applicable).
 for each material joint venture and associate that is material to the reporting entity:
 whether the investment in the joint venture or associate is measured using the equity
method or at fair value.
 summarised financial information about the joint venture or associate.
 if the joint venture or associate is accounted for using the equity method, the fair value
of its investment in the joint venture or associate, if there is a quoted market price for
the investment.
 financial information about the entity’s investments in joint ventures and associates that are
not individually material:
 in aggregate for all individually immaterial joint ventures and, separately,
 in aggregate for all individually immaterial associates.
A company must also disclose:
 the nature and extent of any significant restrictions on the ability of joint ventures or
associates to transfer funds to the entity in the form of cash dividends, or to repay loans or
advances made by the entity.
 when the financial statements used in applying the equity method are as of a date or for a
period that is different from that of the entity:
 the date of the end of the reporting period of the financial statements of that joint
venture or associate; and
 the reason for using a different date or period.

© Emile Woolf International 102 The Institute of Chartered Accountants of Pakistan

 Chapter 6: Other group standards

 the unrecognised share of losses of a joint venture or associate, both for the reporting period
and cumulatively, if the entity has stopped recognising its share of losses of the joint venture
or associate when applying the equity method.

Risks associated with an entity’s interests in joint ventures and associates

A company must disclose:
 commitments that it has relating to its joint ventures separately from the amount of other
commitments
 contingent liabilities incurred relating to its interests in joint ventures or associates (unless
the probability of loss is remote)

2.5 Structured entities

Definition

Structured entity: An entity that has been designed so that voting or similar rights are not the
dominant factor in deciding who controls the entity, such as when any voting rights relate to
administrative tasks only and the relevant activities are directed by means of contractual
arrangements.

Whether an entity is a structured entity or not is important because additional disclosures are
required by IFRS 12 for interests in structured entities.
A structured entity is an entity that has been designed so that voting or similar rights are not the
dominant factor in deciding who controls the entity, such as when any voting rights relate to
administrative tasks only and the relevant activities are directed by means of contractual
arrangements.
The guidance to IFRS 12 states that a structured entity often has some or all of the following
features or attributes:
(a) restricted activities;
(b) a narrow and well-defined objective, such as:
(i) to effect a tax-efficient lease;
(ii) to carry out research and development activities;
(iii) to provide a source of capital or funding to an entity; or
(iv) to provide investment opportunities for investors by passing on risks and rewards
associated with the assets of the structured entity to investors.
(c) insufficient equity to permit the structured entity to finance its activities without subordinated
financial support; and
(d) financing in the form of multiple contractually linked instruments to investors that create
concentrations of credit or other risks (tranches).
A structured entity might be consolidated or unconsolidated depending on the results of the
analysis of whether control exists.
Consolidated structured entities
A company must disclose the terms of any contractual arrangements that could require the parent
or its subsidiaries to provide financial support to a consolidated structured entity.
A company must also disclose any support given where there is no contractual obligation and any
intention to provide financial or other support to a consolidated structured entity.

© Emile Woolf International 103 The Institute of Chartered Accountants of Pakistan

Advanced accounting and financial reporting

Unconsolidated structured entities

A company must disclose information that enables users of its financial statements:
 to understand the nature and extent of its interests in unconsolidated structured entities; and
 to evaluate the nature of, and changes in, the risks associated with its interests in
unconsolidated structured entities.

© Emile Woolf International 104 The Institute of Chartered Accountants of Pakistan

 Certified Finance and Accounting Professional

CHAPTER
Advanced accounting and financial reporting

Foreign currency

Contents
1 IAS 21: The effects of changes in foreign exchange rates
2 The individual entity: accounting requirements
3 The foreign operation: accounting requirements
4 IFRIC 22: Foreign Currency Transactions and Advance
Consideration
5 Disclosure

© Emile Woolf International 105 The Institute of Chartered Accountants of Pakistan

Advanced accounting and financial reporting

1 IAS 21: THE EFFECTS OF CHANGES IN FOREIGN EXCHANGE RATES

Section overview

 Introduction
 Scope
 The two main accounting issues
 Presentation and Functional Currencies
 Other important definitions

1.1 Introduction
Many businesses have transactions and investments that are denominated in foreign currencies.
These transactions need to be translated into the company’s own currency in order to record them
in its ledger accounts. For example:
 a Pakistani company may take out a loan from a French bank in Euros but will record the
loan in its ledger accounts in Rupees; or
 a Pakistani company may sell goods to a Japanese company invoiced in Yen but will record
the sale and the trade receivable in Rupees in its ledger accounts.
Groups often contain overseas entities. A parent company might own a foreign subsidiary or
associate. This foreign entity will normally maintain its accounting records and prepare its financial
statements in a currency that is different from the currency of the parent company and the group’s
consolidated accounts.
For example, if a Pakistani company has a US subsidiary, the financial statements of the US
subsidiary will be prepared in US Dollars, but will need to be translated into Rupees for the purpose
of preparing the group’s consolidated financial statements.

1.2 Scope
This Standard shall be applied:
(a) in accounting for transactions and balances in foreign currencies, except for those derivative
transactions and balances that are within the scope of IFRS 9 Financial Instruments;
(b) in translating the results and financial position of foreign operations that are included in the
financial statements of the entity by consolidation or the equity method; and
(c) in translating an entity’s results and financial position into a presentation currency.

1.3 The two main accounting issues

Transactions, assets and liabilities in foreign currencies are translated or converted from the
foreign currency into the currency of the reporting entity. The process of translation would be quite
simple if exchange rates between currencies remained fixed. However, exchange rates are
continually changing. The translated valuation of foreign currency assets or liabilities in the
statement of financial position might therefore change if they are translated at different times.
The two main accounting issues when accounting for foreign currency items are:
(i) What exchange rate(s) should be used for translation?

(ii) How to account for the gains or losses that arise when exchange rates change?

Before looking at these accounting rules in detail, it is important to understand the precise meaning
of some key terms used in IAS 21.

© Emile Woolf International 106 The Institute of Chartered Accountants of Pakistan

 Chapter 7: Foreign currency

1.4 Presentation and Functional Currencies

IAS 21 identifies three types of currency: the presentation currency, the functional currency and
foreign currency.

Definitions
Presentation currency: The currency in which the financial statements of an entity are presented
Functional currency: The currency of the primary economic environment in which an entity
operates.
Foreign currency: A currency other than the functional currency of the entity

Presentation currency
An entity is permitted to present its financial statements in any currency. This reporting currency is
often the same as the functional currency, but does not have to be.
Functional currency
When a reporting entity records transactions in its financial records, it must identify its functional
currency and make entries in that currency. It will also, typically, prepare its financial statements in
its functional currency. This rule applies to stand-alone entities, parent companies and foreign
operations (such as a foreign subsidiary or a branch). When financial statements prepared in a
functional currency are translated into a different presentation currency, the translation of assets
and liabilities must comply with the rules in IAS 21.
IAS 21 describes the functional currency as:
The currency that mainly influences:
 sales prices for goods and services
 labour, material and other costs of providing goods or services.
The following factors may also provide an evidence of an entity’s functional currency;
 The currency in which funds from financing activities are generated by issuing debt and
equity
 The currency in which receipts from operating activities are usually retained.
The functional currency is not necessarily the currency of the country in which the entity operates
or is based, as the next example shows.

Example: Presentation and functional currencies

P is a UK-registered mining company whose shares are traded on the London Stock Exchange. Its
operating activities take place in the gold and diamond mines of South Africa.
(a) What is the presentation currency of P?
(b) What is its functional currency?
(c) P bought specialised mining equipment from the US, invoiced in US dollars. What type of
currency is the US dollar, using the IAS 21 definitions?

Answer
(a) The presentation currency (reporting currency) is sterling (UK pounds). This is a requirement
of the UK financial markets regulator for UK listed companies.
(b) The functional currency is likely to be South African Rand, even though the company is based
in the UK. This is because its operating activities take place in South Africa and so the
company will be economically dependent on the Rand if the salaries of most of its
employees, and most operating expenses and sales are in Rand.
(c) The US dollars are ‘foreign currency’ for the purpose of preparing P’s accounts.

© Emile Woolf International 107 The Institute of Chartered Accountants of Pakistan

Advanced accounting and financial reporting

IAS 21 requires P to prepare its financial statements in its functional currency (Rand).
However, P is permitted to use Pound Sterling as its presentation currency. If it does use Sterling
as its presentation currency (which it will do, given the UK rules), the translation of assets and
liabilities from Rand to Sterling must comply with the rules in IAS 21.

1.5 Other important definitions

Exchange rate definitions
IAS 21 uses the following terms to describe which exchange rate should be used in the translation.

Definitions
Exchange rate: The rate of exchange between two currencies
Spot rate: The exchange rate at the date of the transaction
Closing rate: The spot exchange rate at the end of the reporting period

To understand the concept of Exchange rate and related definitions, see below illustration: On 16
November 20X1, a German company buys goods from a US supplier, and the goods are priced in
US dollars. The financial year of the company ends on 31 December, and at this date the goods
have not yet been paid for.
The spot rate is the euro/dollar exchange rate on 16 November 20X1, when the transaction
occurred.
The closing rate is the exchange rate at 31 December.
Other definitions
IAS 21 also includes some other terms and definitions.

Definitions
Foreign operation: This is a subsidiary, associate, joint venture or branch whose activities are
conducted in a country or currency different from the functional currency of the reporting entity.
Net investment in a foreign operation: The amount of the reporting entity's interest in the net assets
of a foreign operation.
Exchange difference: A difference resulting from translating a given number of units of one currency
into another currency at different exchange rates.
Monetary items: Units of currency held and assets and liabilities to be received or paid (in cash), in
a fixed number of currency units.

The essential feature of a monetary item is a right to receive (or an obligation to deliver) a fixed or
determinable number of units of currency. Examples include: pensions and other employee
benefits to be paid in cash, cash dividends that are recognised as a liability, accounts receivable /
accounts payable etc.
Non-monetary items are not defined by IAS 21, but they are items that are not monetary items.
They include tangible non-current assets, investments in other companies, investment properties
and deferred taxation (which is a notional amount of tax rather than an actual amount of tax
payable.)

© Emile Woolf International 108 The Institute of Chartered Accountants of Pakistan

 Chapter 7: Foreign currency

2 THE INDIVIDUAL ENTITY: ACCOUNTING REQUIREMENTS

Section overview

 Introduction
 Initial recognition: translation of transactions
 Reporting at the end of each reporting period and gain or loss arising on translation
 Reporting at the settlement of a transaction

2.1 Introduction
An individual company may have transactions that are denominated in a foreign currency. These
must be translated into the company’s functional currency for the purpose of recording the
transactions in its ledger accounts and preparing its financial statements.
These transactions may have to be translated on several occasions. When a transaction or asset
or liability is translated on more than one occasion, it is:
 translated at the time that it is originally recognised; and
 re-translated at each subsequent occasion.
Re-translation may be required, after the transaction has been recognised initially:
 at the end of a financial year (end of a reporting period);
 when the transaction is settled (which may be either before, or after the end of the financial
year).
On each subsequent re-translation, an exchange difference will occur. This gives rise to a gain or
loss on translation from the exchange difference.

2.2 Initial recognition: translation of transactions

On initial recognition, a transaction in a foreign currency must be translated at the spot rate on the
date of the transaction.
If the company purchases goods frequently in the foreign currency, it might be administratively
difficult to record every transaction at the actual spot rate. For practical reasons, IAS 21 therefore
allows entities to use an average rate for a time period, provided that the exchange rate does not
fluctuate significantly over the period.
For example, an entity might use an average exchange rate for a week or a month for translating
all the foreign currency-denominated transactions in that time period.
These rules apply when an entity:
 buys or sells goods or services that will be paid for in a foreign currency;
 borrows or lends money when the interest payments and repayments of principal are in a
foreign currency;
 purchases or disposes of non-current assets in another currency; or
 receives dividends and other payments in another currency.

© Emile Woolf International 109 The Institute of Chartered Accountants of Pakistan

Advanced accounting and financial reporting

Example: Initial recognition

A Pakistani company (with the rupee as its functional currency) has a financial year ending on 31
December.
It buys goods from an Australian supplier (with the Australian dollar as its functional currency) on
1 December 20X6 invoiced in A$10,000.
The Australian supplier is eventually paid in March 20X7.
Exchange rates over the period were as follows:
1 December 20X6 Rs.125/A$1
The purchase/inventory and the trade payable should be recorded initially by translating the
transaction at the spot rate of Rs.125/A$1.
This gives a translated value of Rs. 750,000 for recording in the ledger accounts (Rs.125 
A$10,000).

On 1 December 20X6
Debit Credit
Purchases Rs. 1,250,000
Payables (Rs. 125  A$10,000) Rs. 1,250,000

Being the initial recognition of a purchase of inventory in a foreign currency

Note that for practical purposes, if the entity buys items in A$ frequently, it may be able to use an
average spot rate for a period, for all transactions during that period.
For example, if the Pakistani company bought items from Australia on an ongoing basis it might
adopt a policy of translating all purchases in a month at the average rate for that month.

2.3 Reporting at the end of each reporting period and gain or loss arising on translation
Transactions in a foreign currency are recognised initially at the spot rate on the date of the
transaction.
Balances resulting from such transactions may still ‘exist’ in the statement of financial position at
the end of the financial period.
Exchange rates change over time and the exchange rate at the end of the reporting period will not
be the same as the spot rate on the date of the transaction.
Retranslation of items at a later date will lead to gains or losses if the exchange rates have moved.
The gain or loss is the difference between the original and re-translated value of the item.
There is an exchange gain when an asset increases in value on re-translation, or when a liability
falls in value.
There is an exchange loss when an asset falls in value on re-translation, or when a liability
increases in value.
The rules in IAS 21 for reporting assets and liabilities at the end of a subsequent reporting period
make a distinction between:
 monetary items, such as trade payables and trade receivables, and
 non-monetary items, such as non-current assets and inventory.

© Emile Woolf International 110 The Institute of Chartered Accountants of Pakistan

 Chapter 7: Foreign currency

The rules are as follows, for entities preparing their individual financial statements:

Asset or liability Accounting treatment Treatment of exchange

difference
Monetary items Re-translate to the closing rate Recognised in P&L
at the end of reporting period.
Non-monetary items No re-translation. The Not applicable
carried at cost transaction is left at the original
spot rate.
Non-monetary items Re-translate at the exchange Recognised in the same
carried at fair value rate ruling at the date of the fair location as the revaluation
value adjustment. gain or loss

Example: Subsequent measurement of monetary amount

A Pakistani company (with the rupee as its functional currency) has a financial year ending on 31
December.
It buys inventory from an Australian supplier on 1 December 20X6 invoiced in A$10,000.
The Australian supplier is eventually paid in March 20X7.
Exchange rates over the period were as follows:
1 December 20X6 Rs.118 /A$1
31 December 20X6 Rs.120/A$1
The transaction would be recorded as follows:

On 1 December 20X6
Debit Credit
Purchases Rs.1,180,000
Payables (Rs. 118 A$10,000) Rs.
1,180,000

Being the initial recognition of a purchase of inventory in a foreign currency

On 31 December 20X6
Debit Credit
Statement of profit or loss Rs. 20,000
Payables Rs. 20,000

Being the recognition of the exchange loss arising on the retranslation of a

payable denominated a foreign currency.

Working
Rs.
Liability on initial recognition 1,180,000
Exchange loss (balancing figure) 20,000
Liability on retranslation at the year-end
(Rs. 120 A$10,000) 1,200,000

© Emile Woolf International 111 The Institute of Chartered Accountants of Pakistan

Advanced accounting and financial reporting

In the above example the Pakistani company had purchased inventory. Even if this were still held
at the year-end it would not be retranslated as it is a non-monetary asset.
Sometimes there might be a movement on the carrying amount of a balance denominated in a
foreign currency during a period. The exchange difference could be calculated by applying the
above approach. However, this can be time consuming where there is a lot of movements. An
easier approach is to find the exchange difference as a balancing figure.

Example: Retranslation of monetary item with movement on the account

A Pakistani company whose functional currency is the rupees paid $90,000 into a US dollar
account on 30 June.
The company paid an additional $10,000 into the account on 30 September.
There were no other movements on this account.
Exchange rates over the period were as follows:
30 June: Rs.160/$.
30 September Rs.159/$.
31 December (year-end): Rs. 155/$.
The exchange difference arising at 31 December can be calculated as follows:

Exchange difference: gain or (loss)

a On re-translating June amount Rs. Rs.
$90,000 at rate of Rs.160 14,400,000
$90,000 at closing rate of Rs.155 13,950,000
Exchange loss 450,000
b On re-translating September amount:
$10,000 at average rate of Rs.159 1,590,000
$10,000 at closing rate of Rs.155 1,550,000
Exchange loss 40,000
Exchange loss 490,000

There is an exchange loss because the company has a dollar asset but the dollar has weakened
against the rupee over the period.
This approach might be cumbersome if there are more than a few movements on an account. The
following approach simply records all items at the appropriate rates and identifies the exchange
difference as a balancing figure.

$ Rate Rs.
Balance at start (30 June) 90,000 160 14,400,000
Amount paid in (30 Sept.) 10,000 159 1,590,000

Exchange loss (490,000)

Balance at end (31 Dec.) 100,000 155 15,500,000

© Emile Woolf International 112 The Institute of Chartered Accountants of Pakistan

 Chapter 7: Foreign currency

Example: Retranslation of monetary item with movement on the account

A Pakistani company whose functional currency is the rupee borrowed $90,000 on 30 June.
The company recognised an interest accrual of $10,000 at its year-end (31 December).
There were no other movements on this account.
Exchange rates over the period were as follows:
30 June: Rs.160/$.
Average for the period Rs.159/$.
31 December (year-end): Rs. 155/$.
There is no rule in IAS 21 as to what rate should be used for the accrual of interest. The accrual
could be deemed to arise over the period in which case the average rate would be used or it could
be treated as a year-end transaction in which case the closing rate would be used. The profit for
the period is not affected by the choice of rate as there would be a compensating adjustment in
the amount of the exchange difference.
This is demonstrated below.

Exchange difference (interest at closing rate)

$ Rate Rs.
Balance at start (30 June) 90,000 160 14,400,000
Interest 10,000 1555 1,550,000
Exchange gain (450,000)
Balance at end (31 Dec.) 100,000 155 15,500,000

Exchange difference (interest at average rate)

$ Rate Rs.
Balance at start (30 June) 90,000 160 14,400,000
Interest 10,000 159 1,590,000
Exchange gain (490,000)
Balance at end (31 Dec.) 100,000 155 15,500,000

There is an exchange gain because the company has a dollar liability but the dollar has weakened
against the rupees over the period.

The balancing figure approach can be used in any situation where there are movements on an
amount denominated in a foreign currency.
For example, when consolidating foreign subsidiaries the parent consolidated the subsidiary’s net
assets at the start of the period (in last year’s consolidated statement of financial position) and its
profit for the period (in this year’s consolidated statement of profit or loss. These two figures will
sum to the subsidiary’s net assets at the end of the period in the foreign currency but not when
translated into rupees. The difference is an exchange gain or loss.
This will be covered in a later section.
Revaluations of non-current assets
A non-current asset in a foreign currency might be re-valued during a financial period.
For example, a Pakistani company might own an office property in Thailand. The cost of the office
would have been translated at the spot rate when the property was originally purchased. However,
it might subsequently have been revalued. The revaluation will almost certainly be in Thai baht.
This revalued amount must be translated into the functional currency of the entity (in this example,
rupees).

© Emile Woolf International 113 The Institute of Chartered Accountants of Pakistan

Advanced accounting and financial reporting

Any gain or loss arising on retranslation of this property is recognised in the same place as the
gain or loss arising on the revaluation that led to the retranslation.
If a revaluation gain had been recognised in other comprehensive income in accordance with IAS
16, the exchange difference would also be recognised in other comprehensive income.
If a revaluation gain had been recognised in profit or loss in accordance with IAS 40, the exchange
difference would also be recognised in profit or loss.

Example: Subsequent measurement of monetary amount

A Pakistani company (with the rupee as its functional currency) has a financial year ending on 31
December.
It bought a building in Bahrain on 1 December 20X6 for 100,000 Bahraini dinar (BD).
The building was revalued to BD 120,000 on 31 December 20X6 as permitted by IAS 16.
Exchange rates:
1 December 20X6 Rs. 400/BD1
31 December 20X6 Rs.415/BD1
The transaction would be recorded as follows:

On 1 December 20X6
Debit Credit
Property, plant and equipment 40,000,000
Payables (Rs. 400 BD100,000) 40,000,000

Being the initial recognition of building bought in a foreign currency

On 31 December 20X6
Debit Credit
Property, plant and equipment
(BD 20,000 x Rs.415/BD) 8,300,000
Other comprehensive income 8,300,000
Being the recognition of revaluation gain and exchange gain on retranslation of
carrying amount of a building denominated a foreign currency.

Working
BD Rate Rs.
Building on initial recognition 100,000 400 40,000,000
Revaluation (year-end) 20,000 415 8,300,000
Exchange gain 100,000 15 1,500,000
Building at year end 120,000 415 49,800,000

If the building was an investment property, revalued following the rules in IAS 40 the credit of
Rs.8,300,000 would be to the statement of profit or loss.

© Emile Woolf International 114 The Institute of Chartered Accountants of Pakistan

 Chapter 7: Foreign currency

Practice question 1
A Pakistani company bought a machine from a German supplier for €200,000 on 1
March when the exchange rate was Rs. 190/€.
By 31 December, the end of the company’s accounting year, the exchange rate was Rs.
180/€.
At 31 December, the Pakistani company had not yet paid the German supplier any of the
money that it owed for the machine.
Required
Show the amounts that must be recognised to record this transaction.

2.4 Reporting at the settlement of a transaction

The settlement of a foreign currency transaction involves a receipt or payment in foreign currency.
The receipt or payment is a transaction in its own right and must be recorded at the rate ruling at
the date of the receipt or payment.
There will be exchange difference when the exchange rate at the date of settlement is different to
that at the date of initial recognition of the receivable or payable in question. This is recognised in
the statement of profit or loss.

Example: Settlement of a transaction

A Pakistani company sells goods to a customer in Saudi Arabia for SR 72,000 on 12 September,
when the exchange rate was Rs.42/SR (Saudi riyal).
It received payment on 19 November, when the exchange rate was Rs.44/SR.
The financial year-end is 31 December.
The sale will be initially translated at the spot rate giving rise to revenue and receivables of
Rs.3,024,000 (SR 72,000  Rs.42).
The receipt of the payment is recorded at Rs.3,168,000 (SR 72,000  Rs.44).
The necessary double entries are as follows:

On 19 September
Debit Credit
Receivables 3,024,000
Revenue 3,024,000

On 19 November
Debit Credit
Cash 3,168,000
Receivables 3,024,000
Exchange gain (statement of profit or loss) 144,000

© Emile Woolf International 115 The Institute of Chartered Accountants of Pakistan

Advanced accounting and financial reporting

3 THE FOREIGN OPERATION: ACCOUNTING REQUIREMENTS

Section overview

 Three stages in the consolidation process

 The translation stage
 The consolidation stage
 Consolidation example
 Consolidated statement of profit or loss and other comprehensive income
 Disposal of a foreign subsidiary

3.1 Three stages in the consolidation process

If a company has a foreign operation (such as a foreign subsidiary) that prepares its accounts in a
functional currency that is different from the group’s presentation currency, there are three stages
in the accounting process, for the purpose of preparing consolidated financial statements (or
including the foreign associate or joint venture in the financial statements of the reporting entity).

Stage Description

Adjust and  Ensure that the individual financial statements of the foreign entity are correct
update and up-to-date.
 If any adjustments are required to correct the financial statements of the
foreign entity, these should be made in the statements of the foreign entity
and in its own functional currency.

Translate  The assets and liabilities of the foreign entity should be translated into the
presentation currency of the parent company. (As explained earlier, the
presentation currency of the parent company might be the same or might be
different from its functional currency.)
 The rules for translation are explained below.
Consolidate  After translation, all the financial statements are now in the same currency.
 Normal group accounting principles are now used to prepare the consolidated
accounts of the group.

Given the time pressure in the exam you might consider setting up a proforma answer to allow you
to consolidate translated figures as you go along. In other words, try to do stage 2 and part of stage
3 together. This will allow you to build quickly the easier part of the answer leaving time to
concentrate on the trickier parts.
3.2 The translation stage
The rules set out below apply where the functional currency of the foreign entity is not a currency
suffering from hyperinflation. (Hyperinflation is where the country’s rate of inflation is very high.
When there is hyperinflation, IAS 29 provides special accounting rules, which are described later.)
The normal rules for translation, contained in IAS 21, are as follows:
(1) The statement of financial position
 The assets and liabilities of the foreign operation are translated at the closing rate for
inclusion in the consolidated statement of financial position.
 This is different to the rule for transactions arising at the individual entity level. Both
monetary and non-monetary amounts of subsidiaries are translated at the closing rate.
 This rule also applies to purchased goodwill arising on the acquisition of a foreign
subsidiary.

© Emile Woolf International 116 The Institute of Chartered Accountants of Pakistan

 Chapter 7: Foreign currency

(2) The statement of profit or loss

 Income and expenses are translated at the rates ruling at the date of the transaction
(spot rates) for inclusion in the consolidated statement of profit or loss.
 For practical reasons, average rates for a period may be used as long as they provide
a reasonable approximation of the spot rates when the transactions took place.
Average rates are widely used in practice.
(3) Exchange differences
 All resulting exchange differences are recognised in other comprehensive income for
the period and are credited (gain) or debited (loss) to a separate reserve within the
equity section of the consolidated statement of financial position, and this reserve is
maintained within equity until the foreign operation is eventually disposed of.
 Gains or losses are therefore reported as gains or losses in other comprehensive
income and movements in the separate reserve, and not as a gain or loss in profit or
loss and an increase or reduction in retained earnings.
The gain or loss on translation
The exchange differences on translation (see (3) above) result in a gain or loss. These gains or
losses arise from a combination of two factors:
Income and expense items are translated at the exchange rates ruling during the period (or an
average rate as an approximation) but assets and liabilities are translated at closing rates. The
profit is therefore calculated at the actual (average) exchange rates, but the accumulated profit in
the consolidated statement of financial position is re-translated at the closing rate.
The net assets of the subsidiary were translated at last year’s closing rate at the end of the previous
financial year. These net assets have now been retranslated and included in this year’s statement
of financial position at this year’s closing rate.
IAS 21 states that these differences on translation are not recognised in profit or loss because
changes in the exchange rates for these items have little or no effect on cash flows from operations.
It would therefore be misleading to include them in profit or loss.

Example: Exchange difference arising on retranslation of a foreign subsidiary

A Pakistani parent company has a Singapore subsidiary, which is 80% owned.
The following information is available about the subsidiary for the year to 31 December:

S$
Opening net assets, 1 January 16,000
Retained profit for the year 6,000
Closing net assets, 31 December 22,000

Relevant Rs./S$ exchange rates are as follows:

1 January Rs.125/$
Average for the year Rs.130/$
31 December Rs.135/$

© Emile Woolf International 117 The Institute of Chartered Accountants of Pakistan

Advanced accounting and financial reporting

Example: (continued)

The exchange difference arising can be calculated as follows:

Exchange difference
$ Rate Rs.
Opening net assets 16,000 125 2,000,000
Retained profit for the year 6,000 130 780,000
Exchange gain* 190,000
Closing net assets 22,000 135 2,970,000

* [16,000*(135-125) + 6,000*(135-130)]
Note that the Rs. 190,000 would be reported as a gain in other comprehensive income.
The amount attributable to the parent of Rs. 152,000 (80% of Rs. 190,000) would then be
recognised in a currency translation reserve.
The amount attributable to the non-controlling interest is Rs. 38,000 (20% of Rs. 190,000). This
would be recognised in the non-controlling interest balance in the statement of financial position.

Practice question 2
A Pakistani parent company has a US subsidiary, which is 100% owned.
The following information is available about the subsidiary for the year to 31 December
Year 5:

Opening net assets, 1 January $20,000

Profit for the year $10,000
Closing net assets, 31 December $30,000
Dividends paid $0
Relevant Rs./$ exchange rates are as follows:
1 January Year 5 Rs.160/$
Average for the year Rs.166/$
31 December Year 5 Rs.170/$

Required
Calculate the total gain or loss on translation for the year.
Analyse it into:
a. the gain or loss on re-translating profit in the year; and
b. the gain or loss on re-translating the opening net assets.

3.3 The consolidation stage

After the translation stage, the financial statements of the overseas entity are in the presentation
currency of the parent company.
Consolidation can proceed as normal. However, there are several issues to be aware of:
 Goodwill must be retranslated at each reporting date; and
 A foreign exchange reserve must be included in the consolidated statement of financial
position for the cumulative exchange differences.

© Emile Woolf International 118 The Institute of Chartered Accountants of Pakistan

 Chapter 7: Foreign currency

Purchased goodwill and foreign subsidiaries

A net assets working can be constructed for the subsidiary. This should be constructed in the
foreign currency to identify the net asset balances in the foreign currency at the dates of
consolidation and acquisition. These are then translated into the parent’s currency using the
appropriate rate. This will be shown later.
IAS 21 requires that goodwill and any fair value adjustments arising on the acquisition of a foreign
subsidiary are to be treated as part of the assets and liabilities of the foreign subsidiary. The rules
already described apply to these items.
This means that:
 Goodwill arising on the purchase of the foreign subsidiary (and also any fair value
adjustments to the value of assets of the subsidiary) should be stated in the functional
currency of the foreign subsidiary.
 The goodwill and fair value adjustments will therefore be translated each year at the closing
exchange rate.
A gain or loss on translation will therefore arise (as described above for other assets and liabilities).
The effect of this rule is that goodwill and the acquisition of a foreign operation is re-stated over
time because it is re-translated every year at the new closing exchange rate.
The rationale behind this accounting rule is that the amount paid for the investment in the subsidiary
has been based on the expected future earnings stream. The goodwill relates to a business which
operates in the economic environment of another country and should therefore be expressed in
the functional currency of the foreign subsidiary.

Example: Goodwill arising on the acquisition of a foreign subsidiary and its subsequent
retranslation
A Pakistani parent company bought 80% of the shares of a Singapore company on 1 January at a
cost of Rs. 1,125,000.
The new subsidiary had retained earnings of $11,000 at the date of acquisition. It had share
capital of S$5,000.
There were no fair value adjustments at the date of acquisition.
The parent recognises a proportionate share of non-controlling interest.
Relevant Rs./S$ exchange rates are as follows:
1 January Rs.115/$
31 December Rs.125/$
Goodwill is first calculated in the foreign currency as at the date of acquisition using the rates
appropriate to that date.
Goodwill arising on acquisition $ Rate Rs.
Cost of investment 15,000 115 1,725,000
Less net assets acquired
80%  ($ 5,000 + S$11,000) (12,800) 115 (1,472,000)
Goodwill 2,200 115 253,000
Retranslation at 31 December 2,200 125 275,000
Exchange gain 22,000
The Company would recognise goodwill of Rs.275,000 in the consolidated statement of financial
position at 31 December.
The exchange gain of Rs. 22,000 would be reported as a gain in other comprehensive income.
The amount attributable to the parent is the full Rs. 22,000 as it only relates to the parent’s
investment in the subsidiary.

© Emile Woolf International 119 The Institute of Chartered Accountants of Pakistan

Advanced accounting and financial reporting

Practice question 3
A Pakistani holding company acquired 100% of the capital of a US subsidiary on 30
September Year 6 at a cost of $800,000.
The fair value of the net assets of the subsidiary at that date was $300,000.
The holding company prepares financial statements at 31 December each year.
Relevant exchange rates are as follows:
30 September Year 6 Rs. 160/$
31 December Year 6 Rs.170/$
Required
Show how the goodwill would be accounted for at 31 December.

3.4 Consolidation example

The following example looks at the whole process of foreign currency consolidation, beginning with
the translation of the foreign subsidiary’s accounts and finishing with their consolidation into the
parent group accounts.
Financial numbers for this example were used the previous two examples so you will be familiar
with these.

Example:
H bought 80% of S (a company in Singapore) on 31 December 20X4 (one year ago) when S had
retained earnings of S$ 11,000.
Statements of financial position at 31 December 20X5
H S
Rs. S$
Investment in S 1,125,000
Property, plant and equipment 800,000 10,000
Current assets 1,500,000 14,000
3,425,000 24,000

Share capital 1,000,000 5,000

Retained earnings 2,025,000 17,000
3,025,000 22,000
Current liabilities 400,000 2,000
3,425,000 24,000

Retained earnings b/f 1,425,000 11,000

Retained earnings in the year 600,000 6,000
Retained earnings c/f 2,025,000 17,000

The following exchange rates are relevant:

31 December 20X4 (date of acquisition) Rs. 75/S$

Average for the year Rs. 80/S$
31 December 20X4 Rs. 85/S$

Prepare a consolidated statement of financial position at 31 December 20X5.

© Emile Woolf International 120 The Institute of Chartered Accountants of Pakistan

 Chapter 7: Foreign currency

This text will guide you through the answer process. Many of the numbers are straightforward but
some are little trickier to find.
Remember the three steps described earlier.
Step 1: Deal with any adjustments to the accounts of the subsidiary and parent, e.g. inter-company
trading transactions and inter-company loans. Apply the normal rules for dealing with these.
There are no adjustments in this example so we can proceed to step 2.
Step 2: When the financial statements of the subsidiary have been updated and adjusted as
necessary, translate the subsidiary’s accounts into the reporting currency

Example: Step 2
The subsidiary’s statement of financial position is translated at the closing rate.
Working 1: Translation working

S statement of financial position at 31 December 20X5

S S

S$ Rate Rs.

Property, plant and equip. 10,000 85 850,000

Current assets 14,000 85 1,190,000

24,000 85 2,040,000

Share capital 5,000

Retained earnings 17,000

22,000 Balance 1,870,000

Current liabilities 2,000 85 170,000

24,000 85 2,040,000

The main purpose of this working is to identify values for the assets and liabilities of the
subsidiary so that they can be consolidated.
There is no need to translate the share capital and reserves at the closing rate. These will be
considered later when we look at the net assets summary.
In the above answer we have identified the sum of the share capital and reserves as a balancing
figure. This figure is based on the net assets at the reporting date translated at the closing rate.
Therefore, it must include the exchange differences. We will need to identify these separately.

Step 3: Carry out the consolidation. Some of the numbers are very straightforward – get the easy
marks first by setting up a proforma answer and filling in the blanks as far as you can. Only then
go on to look at the more difficult numbers (goodwill, retained earnings, exchange differences etc.)

© Emile Woolf International 121 The Institute of Chartered Accountants of Pakistan

Advanced accounting and financial reporting

Example: Step 3 (easy numbers)

Consolidated statement of financial position at 31 December 20X5

H S (W1) S
Rs. Rs. Rs.
Goodwill
Property, plant and
equipment 800,000 850,000 1,650,000
Current assets 1,500,000 1,190,000 2,690,000

Share capital 1,000,000 1,000,000

Retained earnings 2,025,000
Translation reserve
NCI
Current liabilities 400,000 170,000 570,000

We now need to start on the more difficult numbers. It is useful (though not essential) to construct
a net asset summary to help with these numbers.

Example: Step 3 (continued)

Working 2: Net asset summary of S

Net assets at Net assets at
the date of the date of
consolidation acquisition Post-acquisition
S$. S$.
Share capital 5,000 5,000
Retained earnings 17,000 11,000
Net assets (S$) 22,000 16,000
Rate 85 75
Net assets (Rs.) 1,870,000 1,200,000 670,000

This information can now be used to calculate NCI and goodwill.

The post-acquisition amount of Rs. 670,000 is not that useful as it is the sum of post-acquisition
profits plus exchange differences and these need to be separated. However, it could be used to
quickly finish off the statement of financial position if you have no time to identify the separate
reserves.

© Emile Woolf International 122 The Institute of Chartered Accountants of Pakistan

 Chapter 7: Foreign currency

Example: Step 3 (continued): NCI and goodwill

The fact pattern from this example was used to illustrate the calculation of goodwill earlier in this
section. It is repeated here for your convenience.

Non-controlling interest Rs.

20% of Rs. 1,870,000 (W2) 374,000

Goodwill arising on acquisition $ Rate Rs.

Cost of investment 15,000 75 1,125,000
Less net assets acquired
80%  (S$ 16,000) 12,800 75 960,000
Goodwill 2,200 75 165,000
Retranslation at 31 December 2,200 85 187,000
Exchange gain 22,000
The exchange gain of Rs. 22,000 would be reported as a gain in other comprehensive income.
The amount attributable to the parent is the full Rs. 22,000 as it only relates to the parent’s
investment in the subsidiary.

The next step is to calculate the consolidated equity balances. These are:
 consolidated retained earnings; and
 translation reserve.
The exchange difference working is useful for both of these calculations.

Example: Step 3 (continued): Exchange difference on retranslation

The fact pattern from this example was used to illustrate the calculation of the exchange difference
in an earlier section (3.2). It is repeated here for your convenience.

Exchange difference
$ Rate Rs.
Opening net assets 16,000 75 1,200,000
Retained profit for the year 6,000 80 480,000
Exchange gain 190,000
Closing net assets 22,000 85 1,870,000

The Rs. 190,000 would be reported as a gain in other comprehensive income.

The amount attributable to the parent of Rs. 152,000 (80% of Rs. 190,000) would then be
recognised in a currency translation reserve.
The amount attributable to the non-controlling interest is Rs. 38,000 (20% of Rs. 190,000). This
would be recognised in the non-controlling interest balance in the statement of financial position.

© Emile Woolf International 123 The Institute of Chartered Accountants of Pakistan

Advanced accounting and financial reporting

Example: Step 3 (continued): Total exchange difference

Exchange difference arises on the retranslation of the goodwill and on the retranslation of the
financial statements of the subsidiary.

Exchange difference

Attributable to Attributable to
Total parent NCI

Rs. Rs. Rs.

On goodwill 22,000 22,000 nil

On net assets of S 190,000 152,000 38,000

Closing net assets 212,000 174,000 38,000

The Rs. 212,000 is reported as a gain in other comprehensive income.

The amount attributable to the parent of Rs. 174,000 is recognised in a currency translation
reserve.
The amount attributable to the non-controlling interest is Rs. 38,000 is recognised in the non-
controlling interest balance in the statement of financial position.

The next step is to calculate the equity balances for inclusion on the statement of financial position.

Example: Step 3 (continued): Equity balances

These can be calculated as follows (by using a working which is in fact an extract from the
statement of changes in equity).

Retained Non-controlling Translation

earnings interest reserve

Rs. Rs. Rs.

Balance at start 1,425,000 240,000

Profit for the year 984,000 96,000

All of H 600,000

Share of S:

80% of (6,000  Rs. 80) 384,000

20% of (6,000  Rs. 80) 96,000

984,000 96000

Exchange difference 38,000 174,000

Balance at end 2,409,000 374,000 174,000

The non-controlling interest calculation is not needed but is shown for completeness.

© Emile Woolf International 124 The Institute of Chartered Accountants of Pakistan

 Chapter 7: Foreign currency

The consolidated statement of financial position can now be completed as follows:

Example: Step 3 (continued): Completion

Consolidated statement of financial position at 31 December 20X5

H S (W1) S

Rs. Rs. Rs.

Goodwill 187,000

Property, plant and

equipment 800,000 850,000 1,650,000

Current assets 1,500,000 1,190,000 2,690,000

4,527,000

Share capital 1,000,000 1,000,000

Retained earnings 2,025,000 2,409,000

Translation reserve 174,000

NCI 374,000

Current liabilities 400,000 170,000 570,000

4,527,000

An aside
Note that in the above the retained earnings (Rs. 2,409,000) and the translation reserve
(Rs.174,000) sum to Rs. 2,583,000.
This can be proved by using the post-acquisition balance found in the net asset working.

Example: Step 3 (continued): Proof of consolidated reserves total

Consolidated reserves (total) Rs.

All of H 2,025,000

Share of S (post acquisition) = 80%  Rs.670,000 (W2) 536,000

Exchange difference on retranslation of goodwill 22,000

2,583,000

3.5 Consolidated statement of profit or loss and other comprehensive income

This section continues and expands (slightly) the previous example to show how to prepare the
consolidated statement of profit or loss and other comprehensive income.

© Emile Woolf International 125 The Institute of Chartered Accountants of Pakistan

Advanced accounting and financial reporting

This is quite straightforward once the exchange differences arising in the period have been
calculated.
Example: Consolidated statement of profit or loss and other comprehensive income
H bought 80% of S (a company in Singapore) on 31 December 20X4 (one year ago).
The following exchange rates is relevant:
Average for the year Rs. 80/S$
Statements of profit and loss for the year ended 31 December 20X5
H S
Rs. S$
Revenue 2,200,000 14,000
Expenses (1,600,000) (8,000)
Profit 600,000 6,000

Consolidated statement of profit or loss and other comprehensive income is prepared as follows.

Translation working
There are no adjustments as required to be made in step 1 in this example so we can proceed to
step 2.

Example: Step 2
The subsidiary’s statement of financial position is translated at the closing rate.
Working 1: Translation working
S statement of profit or loss for the year ending 31 December 20X5
S S
S$ Rate Rs.
Revenue 14,000 80 1,120,000
Expenses (8,000) 80 (640,000)
Profit 6,000 80 480,000

Consolidation
Example: Step 3
Consolidated statement of profit or loss and other comprehensive income for the year ending 31
December 20X5
Statement of profit or loss
H S (W1) S
Rs. Rs. Rs.
Revenue 2,200,000 1,120,000 3,320,000
Expenses (1,600,000) (640,000) (2,240,000)
Profit 600,000 480,000 1,080,000
Other comprehensive income:
Exchange gain (as before – Rs.22,000 + Rs. 190,000) 212,000
Total comprehensive income for the year 1,292,000
Profit attributable to:
Parent (balance) 984,000
Non-controlling interest (20%  Rs. 480,000) 96,000
1,080,000

© Emile Woolf International 126 The Institute of Chartered Accountants of Pakistan

 Chapter 7: Foreign currency

Example: Step 3 (continued)

Other comprehensive income attributable to:
Parent (Rs.22,000 + (80%  Rs. 190,000)) 174,000
Non-controlling interest (20%  Rs. 190,000) 38,000
Total comprehensive income for the year 212,000

3.6 Disposal of a foreign subsidiary

Most of the accounting rules for the disposal of a foreign subsidiary, or for the partial disposal of a
foreign subsidiary, are set out in IFRS 10.
However IFRS 10 does not deal with the accounting treatment of the balance on the separate
equity reserve account when a foreign subsidiary is disposed of. This matter is dealt with by IAS
21.
 When the entire investment in a foreign subsidiary is disposed of, the cumulative balance in
the separate equity reserve (which represents amounts previously recognised in other
comprehensive income) should now be reclassified from equity to profit and loss.
 If there was a non-controlling interest in the subsidiary, the NCI is derecognised in the
consolidated statement of financial position. Amounts previously recognised in other
comprehensive income and attributed to NCI must not be reclassified and recognised in
profit or loss of the reporting entity.
 When a proportion of an investment in a foreign subsidiary is disposed of, a proportionate
share of the amounts previously recognised in other comprehensive income (the cumulative
balance in the separate equity reserve) should now be reclassified from equity to profit or
loss.
When income previously recognised as other comprehensive income is reclassified as a gain or
loss to profit or loss as a re-classification adjustment, there must be an offsetting loss or gain in
other comprehensive income, to avoid double-counting of the gain (or loss).
Example: Disposal
A company held 100% of the equity of a subsidiary S, but sold the entire investment on 1 June
when the carrying value of the net assets S and the purchased goodwill were Rs.30 million. The
consideration received from selling the shares was Rs.37 million.
The company had previously recognised exchange gains of Rs.2 million in other comprehensive
income on its investment in S.
Required
Show the amount to be recognised in the statement of profit or loss in respect of this disposal.

Answer
The company should recognise Rs.9 million in profit or loss for the financial period when the
disposal occurs as follows:
Rs.m
Consideration received from sale of shares 37.0
Carrying value of net assets of S 30.0
Gain 7.0
Exchange gain previously recognised in other comprehensive income
(reclassification adjustment) 2.0
Total gain recognised in profit or loss 9.0
A debit of Rs.2 million should be recognised in other comprehensive income, to avoid double
counting of the income previously recognised as other comprehensive income but now reclassified
in profit or loss.
Profit or Loss Statement
- Gain from Disposal of Subsidiary 9
Other Comprehensive Income
- Reclassification of gain to Profit or loss statement which was
previously recognized in OCI (2)

© Emile Woolf International 127 The Institute of Chartered Accountants of Pakistan

Advanced accounting and financial reporting

4 IFRIC 22: FOREIGN CURRENCY TRANSACTIONS AND ADVANCE

CONSIDERATION

Section overview

 Background
 Scope
 Issues and Consensus

IFRIC 22: Foreign Currency Transactions and Advance Consideration was issued by International
Accounting Standards Board in December 2016 for an entity to record foreign currency transaction.
4.1 Background
IAS 21 The Effects of Changes in Foreign Exchange Rates requires an entity to record a foreign
currency transaction, on initial recognition in its functional currency. It is done by applying spot
exchange rate between the functional currency and the foreign currency (the exchange rate) at the
date of the transaction.
When an entity pays or receives consideration in advance in a foreign currency, it generally
recognises a non-monetary asset or non-monetary liability before the recognition of the related
asset, expense or income. The related asset, expense or income (or part of it) is the amount
recognised applying relevant Standards, which results in the derecognition of the non-monetary
asset or non-monetary liability arising from the advance consideration. The receipt or payment of
advance consideration in a foreign currency is not restricted to revenue transactions. Accordingly,
to clarify the date of the transaction for the purpose of determining the exchange rate to use on
initial recognition of the related asset, expense or income when an entity has received or paid
advance consideration in a foreign currency was felt needed.
4.2 Scope
IFRIC 22 applies to a foreign currency transaction (or part of it) when an entity recognises a non-
monetary asset or non-monetary liability arising from the payment or receipt of advance
consideration before the entity recognises the related asset, expense or income (or part of it).
It does not apply when an entity measures the related asset, expense or income on initial
recognition:
a) at fair value; or
b) at the fair value of the consideration paid or received at a date other than the date of initial
recognition of the non-monetary asset or non-monetary liability arising from advance
consideration (for example, the measurement of goodwill applying IFRS 3 Business
Combinations).
An entity is not required to apply this Interpretation to:
a) income taxes; or
b) insurance contracts (including reinsurance contracts) that it issues or reinsurance contracts
that it holds.
4.3 Issue and consensus
IFRIC 22 addresses how to determine the date of the transaction for the purpose of determining
the exchange rate to use on initial recognition of the related asset, expense or income (or part of
it) on the derecognition of a non-monetary asset or non-monetary liability arising from the payment
or receipt of advance consideration in a foreign currency.
In this respect the date of the transaction for the purpose of determining the exchange rate to use
on initial recognition of the related asset, expense or income (or part of it) is the date on which an
entity initially recognises the non-monetary asset or non-monetary liability arising from the payment
or receipt of advance consideration. If there are multiple payments or receipts in advance, the entity
shall determine a date of the transaction for each payment or receipt of advance consideration.

© Emile Woolf International 128 The Institute of Chartered Accountants of Pakistan

 Chapter 7: Foreign currency

5 DISCLOSURE
An entity shall disclose:

(a) the amount of exchange differences recognised in profit or loss except for those arising on financial
instruments measured at fair value through profit or loss in accordance with IFRS 9; and

(b) net exchange differences recognised in other comprehensive income and accumulated in a
separate component of equity, and a reconciliation of the amount of such exchange differences at
the beginning and end of the period.

© Emile Woolf International 129 The Institute of Chartered Accountants of Pakistan

Advanced accounting and financial reporting

SOLUTIONS TO PRACTICE QUESTIONS

Solutions 1
On initial recognition
The machine and resulting liability are recognised initially at Rs. 38,000,000 (€200,000  Rs.190).
31 December
The liability is a monetary amount and must be retranslated at the closing rate. This results in an
amount of Rs.36,000,000 (€200,000  Rs.180).
This is achieved by recognising an exchange gain of Rs. 2,000,000.
On 31 December
Debit Credit
Payables Rs. 2,000,000
Statement of profit or loss Rs. 2,000,000

The machine is a non-monetary item carried at cost. Therefore, it is not re-translated.

Solutions 2
a Exchange difference
$ Rate Rs.
Opening net assets 20,000 160 3,200,000
Profit for the year 10,000 166 1,660,000
Exchange gain 240,000
Closing net assets 30,000 170 5,100,000

The entire profit for the year is included in accumulated profit at the end of the year, because no
dividends were paid during the year.
b Exchange difference: gain or (loss)
a On re-translating the opening net assets: Rs. Rs.
$20,000 at opening rate of 160 3,200,000
$20,000 at closing rate of 170 3,400,000
200,000
b On re-translating the profit for the year:
$10,000 at average rate of 166 1,660,000
$10,000 at closing rate of 170 1,700,000
40,000
Exchange gain arising 240,000

Solutions 3
Goodwill arising on acquisition $ Rate Rs.
Cost of investment 800,000 160 128,000,000
Minus: Net assets acquired 300,000 160 48,000,000
Goodwill 500,000 160 80,000,000
Retranslation at 31 December 500,000 170 85,000,000
Exchange gain 5,000,000

© Emile Woolf International 130 The Institute of Chartered Accountants of Pakistan

 Certified Finance and Accounting Professional

CHAPTER
Advanced accounting and financial reporting

IAS 7: Statements of cash flows

Contents
1 Statements of cash flows: Introduction
2 Consolidated statement of cash flows
3 Non-controlling interests and associates (or JVs) in the
statement of cash flows
4 Acquisitions and disposals of subsidiaries in the statement
of cash flows
5 Reporting and Disclosures

© Emile Woolf International 131 The Institute of Chartered Accountants of Pakistan

Advanced accounting and financial reporting

1 STATEMENTS OF CASH FLOWS: INTRODUCTION

Section overview

 Purpose
 Benefits
 Illustrative Format
 Direct method: Accruals based figures
 Working capital adjustments

1.1 Purpose
IAS 1 states that a statement of cash flows is a part of a complete set of the financial statements
of an entity. It provides information about:
 the cash flows of the entity during the reporting period, and
 the changes in cash and cash equivalents during the period.
A statement of cash flows groups inflows and outflows of cash under three broad headings:
 cash from operating activities;
 cash used in (or obtained from) investing activities;
 cash paid or received in financing activities.
Illustration: Statement of cash flows
Net cash generated from / (utilized) in operating activities X/(X)
Net cash generated from / (utilized) in investing activities X/(X)
Net cash generated from / (utilized) in financing activities. X/(X)
Net increase / (decrease) in cash and cash equivalents X/(X)
Cash and cash equivalents at the beginning of the period X/(X)
Cash and cash equivalents at the end of the period X/(X)

A statement of cash flows reports the change in the amount of cash and cash equivalents held by
the entity during the financial period.
Cash and cash equivalents

Definition: Cash, cash equivalents and cash flows

Cash comprises cash on hand and demand deposits.
Cash equivalents are short-term, highly liquid investments that are readily convertible to known
amounts of cash and which are subject to an insignificant risk of changes in value.
Cash flows are inflows and outflows of cash and cash equivalents.

Cash equivalents are held for the purpose of meeting short-term cash commitments rather than for
investment or other purposes. For an investment to qualify as a cash equivalent it must be readily
convertible to a known amount of cash and be subject to an insignificant risk of changes in value.
Therefore, an investment normally qualifies as a cash equivalent only when it has a short maturity
of, say, three months or less from the date of acquisition.
Any short term borrowing / running finance facility availed by the entity is also taken into account
while calculating cash and cash equivalents. Cash flows exclude movements between items that
constitute cash or cash equivalents because these components are part of the cash management
of an entity rather than part of its operating, investing and financing activities. Cash management
includes the investment of excess cash in cash equivalents.

© Emile Woolf International 132 The Institute of Chartered Accountants of Pakistan

 Chapter 08: IAS 7: Statements of cash flows

1.2 Benefits
A statement of cash flow is beneficial for the users of the financial statements in many ways;
(a) Cash flow information is harder to manipulate as there is no estimation involved.
(b) It can provide more detail about the quality of the entity’s revenue, for example, whether
customers are (in general) paying their invoices in time.
(c) It evaluates the changes in net assets of an entity (e.g. invest / expand further if sufficient cash
balance is available)
(d) It can review the financial structure (including its liquidity and solvency),
(e) It can facilitate a comparative cash flow analysis of various company’s in similarly industry
(f) Cash accounting methods can be easier to understand by all users.
(g) Cash flow statement majorly used in preparing the cash budget for future needs and helps in
knowing the periodical requirement of cash in the business.

1.3 Illustrative Format

IAS 7 does not include a format that must be followed. However, it gives illustrative examples of
formats that meet the requirements in the standard.
This section provides examples of these.

Illustration: Statement of cash flows

Rs. Rs.
Net cash flow from operating activities 75,300

Cash flows from investing activities:

Acquisition of shares (debentures, etc.) (5,000)
Purchase of property, plant and machinery (35,000)
Proceeds from sale of non-current assets 6,000
Interest received/dividends received 1,500
Net cash used in investing activities (32,500)

Cash flows from financing activities:

Proceeds from issue of shares 30,000
Proceeds from new loan 10,000
Repayment of loan (17,000)
Dividends paid to shareholders (25,000)
Net cash used in financing activities (2,000)
Net increase/decrease in cash and cash equivalents 40,800
Cash and cash equivalents at the beginning of the year 5,000
Cash and cash equivalents at the end of the year 45,800

Operating cash flows

IAS 7 permits two methods of presenting the cash flows from operating activities:
 the direct method, and
 the indirect method.

© Emile Woolf International 133 The Institute of Chartered Accountants of Pakistan

Advanced accounting and financial reporting

For clarity, what this means is that there are two approaches to arrive at the figure of Rs.75,300 in
the above example.
IAS 7 allows entities to use either method of presentation. It encourages entities to use the direct
method. However, the indirect method is used more in practice because it is simple to prepare the
cash flow statement using information from the other two components of general purpose financial
statements (i-e. the profit and loss account and balance sheet). Most companies use the accrual
method of accounting, so the profit or loss account and balance sheet will have figures consistent
with this method.
The two methods differ only in the way that they present the cash flows for cash generated from
operations. In all other respects, the figures in the statement of cash flows using the direct method
are identical to the figures in a statement using the indirect method – cash flows from investing
activities and financing activities are presented in exactly the same way.
The indirect method
The indirect method identifies the cash flows from operating activities by adjusting the profit before
tax figure. It arrives at the cash from operating activities figure indirectly by reconciling a profit
figure to a cash figure.
The starting point for the statement of cash flows for a company is the profit before taxation figure.
This profit is adjusted to calculate the amount of cash received from the customers or cash paid to
the suppliers or employees etc.
The adjustments are to remove the effect of:
 Non-cash items, for example:
 Depreciation and amortisation;
 Gain or loss on disposal of non-current assets;
 Accruals based figures, for example:
 Interest income or expense;
 Movement on working capital items (receivables, payables and inventory).
The following illustration shows how the net cash flow from operating activities figure seen in the
previous example was arrived at using the indirect method.
Illustration: The indirect method
Statement of cash flows: indirect method Rs. Rs.
Cash flows from operating activities
Profit before taxation 80,000
Adjustments for:
Depreciation and amortisation charges 20,000
Interest charges in the statement of comprehensive income 2,300
Gains on disposal of non-current assets (6,000)
Losses on disposal of non-current assets 4,500
100,800
Increase in trade and other receivables (7,000)
Decrease in inventories 2,000
Increase in trade payables 3,000
Cash generated from operations 98,800
Taxation paid (tax on profits) (21,000)
Interest charges paid (2,500)
Net cash flow from operating activities 75,300

© Emile Woolf International 134 The Institute of Chartered Accountants of Pakistan

 Chapter 08: IAS 7: Statements of cash flows

The direct method

The direct method calculates the cash flow from operating activities by calculating cash received
from customers, cash paid to suppliers and so on.
The following illustration shows how the net cash flow from operating activities figure seen in the
previous example was arrived at using the direct method.

Illustration: The direct method

Statement of cash flows: direct method Rs.

Cash flows from operating activities
Cash receipts from customers 348,800
Cash payments to suppliers (70,000)
Cash payments to employees (150,000)
Cash paid for other operating expenses (30,000)
Cash generated from operations 98,800
Taxation paid (tax on profits) (21,000)
Interest charges paid (2,500)
Net cash flow from operating activities 75,300

The figures in the two statements are identical from ‘Cash generated from operations’ down to the
end. The only differences are in the presentation of the cash flows that produced the ‘Cash
generated from operations’.
IAS 7 allows some variations in the way that cash flows for interest and dividends are presented
in a statement of cash flows, although the following should be shown separately:
 interest received
 dividends received
 interest paid
 dividends paid.

1.4 Direct method: Accruals based figures

Interest
The interest liability at the start of the year and the interest charge during the year is the most the
business would pay. If the business had paid nothing it would owe this figure. The difference
between this amount and the liability at the end of the year must be the amount that the business
has paid.

Example: Interest paid

A company had liabilities in its statement of financial position at the beginning and at the end of
20X4, as follows:

Interest (Rs.)
Beginning of 20X4 4,000
End of 20X4 3,000

During the year, interest charges in the income statement were Rs. 22,000.

© Emile Woolf International 135 The Institute of Chartered Accountants of Pakistan

Advanced accounting and financial reporting

The interest payment for inclusion in the statement of cash flows can be calculated as follows:
Rs.
Liability at the start of the year 4,000
Charge for the year 22,000
Total amount payable in the year 26,000
Liability at the end of the year (3,000)
Cash paid 23,000

Taxation
The tax paid is the last figure in the operating cash flow calculation.

Example: Taxation paid

A company had liabilities in its statement of financial position at the beginning and at the end of
20X4, as follows:

Taxation (Rs.)
Beginning of 20X4 53,000
End of 20X4 61,000

During the year, taxation on profits was Rs. 77,000.

The tax payment (cash flows) for inclusion in the statement of cash flows can be calculated as
follows:
Rs.
Tax liability at the start of the year 53,000
Charge for the year 77,000
Total amount payable 130,000
Tax liability at the end of the year (61,000)
Cash paid 69,000

Deferred taxation
A deferred tax balance might be an asset or a liability. Deferred tax liability is more common (in
practice and in questions) so this discussion will be about liabilities.
A deferred tax liability is an amount that a company expects to pay in the future. Therefore, it does
not involve cash effects to date.
Any movement on the deferred tax liability will be due to a double entry to tax expense in the profit
or loss section of the statement of comprehensive income.
There are two possible courses of action in dealing with deferred tax. Either:
 ignore it entirely and work with numbers that exclude the deferred tax (in effect this was what
happened in the example above where there was no information about deferred tax); or
 include it in every tax balance in the working.

© Emile Woolf International 136 The Institute of Chartered Accountants of Pakistan

 Chapter 08: IAS 7: Statements of cash flows

The second approach is usually used.

Example: Deferred tax

A company had liabilities in its statement of financial position at the beginning and at the end of
20X4, as follows:
Taxation Deferred
(Rs.) taxation (Rs.)
Beginning of 20X4 53,000 20,000
End of 20X4 61,000 30,000

The tax expense for the year in the statement of profit or loss was Rs. 87,000. This was made
up of the current tax expense of Rs. 77,000 and the deferred tax of Rs. 10,000.

The tax payment (cash flows) for inclusion in the statement of cash flows can be calculated as
follows:
Rs.
Liability at the start of the year (53,000 + 20,000) 73,000
Charge for the year (77,000 + 10,000) 87,000

Total amount payable in the year 160,000

Liability at the end of the year (61,000 + 30,000) (91,000)

Cash paid 69,000

1.5 Working capital adjustments

Definition
Working capital is current assets less current liabilities.

The previous section showed that taxation and interest cash flows can be calculated by using a
figure from the statement of comprehensive income and adjusting it by the movement on the
equivalent balances in the statement of financial position.
This section shows how this approach is extended to identify the cash generated from operations
by making adjustments for the movements between the start and end of the year for elements of
working capital, namely:
 trade receivables and prepayments;
 inventories; and
 trade payables and accruals.
Any change in the balance of each line item of working capital from one period to another will affect
a company's cash flows. For example, if accounts receivable increase at the end of the year, this
generally means that the company collected less money from its customers than it recorded in
sales (keeping in view that credit sales remain constant) during the same year. This is a negative
event for cash flow perspective and may contribute to the "Net changes in current assets and
current liabilities" on the company's cash flow statement to be negative. On the other side, if
accounts payable increases (keeping in view that credit purchases remain same), it means a
company is able to pay its suppliers more slowly, which is a positive for cash flow.

© Emile Woolf International 137 The Institute of Chartered Accountants of Pakistan

Advanced accounting and financial reporting

Assuming that the calculation of the cash flow from operating activities starts with a profit (rather
than a loss) the adjustments are as follows:

Increase in balance from start to Decrease in balance from start

Balance
the end of the year to the end of the year
Receivables Subtract from profit before tax Add back to profit before tax
Inventory Subtract from profit before tax Add back to profit before tax
Payables Add back to profit before tax Subtract from profit before tax

Rationale:
1) Accounts Receivable:
If Accounts Receivable have increased during the year, this implies that the company has not
received cash as compared to the increase in credit sales. This otherwise means that the cash
sales are lesser than the overall sales recorded in the P&L, therefore, we will deduct the
increase in receivable balance from the cash flows to arrive at the cash sale figure and vice
versa for decrease in Accounts Receivable.
2) Inventory:
If inventory have increased in volume and balances from start of the year, this means that the
cost of sales reported during the period in the P&L on accrual basis has not accounted for the
actual cash impact as during calculation of cost of sales, we deduct the closing inventories,
however, since the closing inventory has increased when compared with opening stock, that
means the actual cash impact has been neutralized. Therefore, to take the actual cash impact,
we deduct the increase in inventory balance and vice versa for decrease in inventory.
3) Accounts Payable
If Accounts payable have increased during the year, means that the entity has not paid much
cash when compared to the increase in credit purchases (under Cost of Sales), this means
that the cash payments are less than the expenses recorded in the P&L, therefore we will add
the increase in payable balance in the cash flows to arrive at the cash expenses figure. Vice
versa for decrease in accounts payable balance.

Practice question 1
A company made an operating profit before tax of Rs. 16,000 in the year just ended.
Depreciation charges were Rs. 15,000.
There was a gain of Rs. 5,000 on disposals of non-current assets and there were no interest
charges. Values of working capital items at the beginning and end of the year were:

Receivables Inventory Trade payables

Beginning of the year Rs. 9,000 Rs. 3,000 Rs. 4,000
End of the year Rs. 6,000 Rs. 5,000 Rs. 6,500

Taxation paid was Rs. 4,800.

Required
Calculate the amount of cash generated from operations, as it would be shown in a statement of
cash flows using the indirect method.

© Emile Woolf International 138 The Institute of Chartered Accountants of Pakistan

 Chapter 08: IAS 7: Statements of cash flows

2 CONSOLIDATED STATEMENT OF CASH FLOWS

Section overview

 The special features of a consolidated statement of cash flows

 Illustrative format

2.1 The special features of a consolidated statement of cash flows

A consolidated statement of cash flows is prepared largely from the consolidated statement of
financial position, statement of profit or loss and other comprehensive income and statement of
changes in equity. The rules for preparing a group statement of cash flows are similar to the rules
for a statement of cash flows for an individual entity.
However, there are additional items in a consolidated statement of cash flows that are not found
in the statement of cash flows of an individual company. The most significant of these are cash
flows (or adjustments to profit before tax) relating to:
 non-controlling interests;
 associates (or JVs);
 and acquiring or disposing of subsidiaries during the year.
Exchange rate differences
A gain or loss arising from exchange rate differences is not a cash flow item. When the indirect
method is used to present cash flows from operating activities, it is therefore necessary to make
an adjustment to get from ‘profit’ to ‘cash flow’.
 A loss arising from exchange rate differences (shown in the example that follows as a
‘foreign exchange loss’) must be added back.
 A gain arising from exchange rate differences must be subtracted.

2.2 Illustrative format

It might be useful to look at the format of a consolidated statement of cash flows, to see where
these items appear. The indirect method is used here to present the cash flows from operating
activities.

© Emile Woolf International 139 The Institute of Chartered Accountants of Pakistan

Advanced accounting and financial reporting

Illustration: X Plc: Consolidated statement of cash flows for the year ended 31 December 20X7

Rs. 000 Rs. 000

Cash flows from operating activities
Profit before tax 440
Adjustments for:
Depreciation and amortisation charges 450
Loss on disposal of plant and machinery 50
Share of profit of associates and joint ventures (100)
Foreign exchange loss 40
Investment income (25)
Interest expense 25
880
Increase in trade and other receivables (80)
Increase in inventories (60)
Increase in trade payables 40
Cash generated from operations 780
Interest paid (30)
Income taxes paid (200)
Net cash from operating activities 550
Cash flows from investing activities
Acquisition of subsidiary, net of cash acquired (note 1) (450)
Purchase of property, plant and equipment (note 2) (220)
Proceeds from the sale of equipment 30
Interest received 25
Dividends received from associates 45
Net cash used in investing activities (570)
Cash flows from financing activities
Proceeds from the issue of share capital 500
Proceeds from long-term loan 100
Redemption of debt securities (150)
Payment of finance lease liabilities (80)
Dividends paid to non-controlling interests (70)
Dividends paid to parent company shareholders (200)
Net cash inflow from financing activities 100
Net increase in cash and cash equivalents 80
Cash and cash equivalents at the start of the year (note 3) 150
Cash and cash equivalents at the end of the year (note 3) 230

© Emile Woolf International 140 The Institute of Chartered Accountants of Pakistan

 Chapter 08: IAS 7: Statements of cash flows

Notes to the statement of cash flows

Illustration: Notes to the statement of cash flows

Note 1: Acquisition of subsidiary
During the year, the group acquired a subsidiary A Limited. The fair value of assets acquired and
liabilities assumed were as follows:

Rs. 000
Cash 50
Inventories 90
Trade receivables 60
Property, plant and equipment 870
Trade payables (70)
Long-term loan (200)
Total purchase price 800
Minus cash of A Limited (50)
750
Shares issued as part of the purchase price (300)
Cash flow on acquisition net of cash acquired 450

Note 2: Property, plant and equipment

During the year, the group acquired property, plant and equipment with a total cost of Rs. 400,000,
of which Rs. 180,000 was acquired by means of finance leases. Cash payments of Rs. 220,000
were made to acquire property, plant and equipment.

Note 3: Cash and cash equivalents

Cash and cash equivalents consist of cash in hand, bank balances, and short term investments
(having maturity within 3 months). Cash and cash equivalents in the statement of cash flows
comprise the following amounts in the consolidated statement of financial position:

20X7 20X6
Rs. 000 Rs. 000
Cash in hand and balances with banks 120 110
Short-term investments 210 80
Cash and cash equivalents as previously reported 330 190
Effect of exchange rate changes - (40)
Cash and cash equivalents as re-stated 330 150

© Emile Woolf International 141 The Institute of Chartered Accountants of Pakistan

Advanced accounting and financial reporting

3 NON-CONTROLLING INTERESTS AND ASSOCIATES (OR JVS) IN THE

STATEMENT OF CASH FLOWS

Section overview

 Obtaining the required figures for cash flows

 Non-controlling interests and the group statement of cash flows
 Dividends paid to non-controlling interests and foreign exchange adjustments
 Associates (or JVs) and the group statement of cash flows
 Calculating dividends received from an associate (or JV)

3.1 Obtaining the required figures for cash flows

The cash flows and adjustments in a group statement of cash flows are obtained from the other
group financial statements. You should expect an examination question to provide you with an
opening and closing consolidated statement of financial position, together with the related
consolidated statement of profit or loss and other comprehensive income.
A group statement of cash flows reports the cash flows that affect the group’s consolidated cash
(and cash equivalents). Any transactions not affecting the group cash position should not be shown
in the statement of cash flows, except (with the indirect method) where a non-cash item is
presented as an adjustment to the profit before tax to calculate the ‘Cash generated from
operations’.

3.2 Non-controlling interests and the group statement of cash flows

Unless there is an acquisition or a disposal of a subsidiary during the year, the only cash flow
relating to non-controlling interests is the amount of dividends paid to the non-controlling interests
by subsidiaries.
This might have to be calculated as a balancing figure, using the following calculation:

Illustration: Dividends paid to NCI

Rs.

Non-controlling interest in group net assets at the beginning of the year X

Non-controlling interest in profits after tax for the year (X)

Dividends paid to non-controlling interests (balancing figure) (X)

Non-controlling interest in group net assets at the end of the year X

The dividends paid to non-controlling interests by subsidiaries are usually included in the ‘Cash
flows from financing activities’ part of the statement of cash flows of the subsidiary statement of
cash flows. (This is the same part of the statement of cash flows where dividends paid to the parent
company shareholders are usually shown.)

© Emile Woolf International 142 The Institute of Chartered Accountants of Pakistan

 Chapter 08: IAS 7: Statements of cash flows

Example: Dividends paid to NCI

The following information has been extracted from consolidated financial statements of P, a
holding company which prepares accounts to 31 December. P has a subsidiary Q, for which an
interim dividend has been paid before the end of the financial year.
20X7 20X6
Rs. 000 Rs. 000
Non-controlling interest in group net assets 1,510 1,380
Non-controlling interest in consolidated profit after taxation 250 470
Required
What figure should appear in the consolidated statement of cash flows for the year to 31 December
20X7 for the dividends paid to non-controlling interests?
Under what heading will this figure appear in the group statement of cash flows?

Answer
Rs. 000
Non-controlling interest in group net assets at the beginning of the year 1,380
Non-controlling interest in profits after tax for the year 250
1,630
Dividends paid to non-controllinginterests (balancing figure) (120)
Non-controlling interest in group net assets at the end of the year 1,510
The dividend paid of Rs. 120,000 will be disclosed as a cash flow from financing activities.

Practice question 2
The following information has been extracted from the consolidated financial statements of P, a
holding company which prepares accounts to 31 December each year:
Year 4 Year 3
Rs. 000 Rs. 000
Dividends payable to non-controlling interests 200 320
Non-controlling interests in group equity 1,560 1,380
Non-controlling interest in profit for the year 240 220
Required
What figure will appear in the consolidated statement of cash flows for the year to 31 December
Year 4 for dividend paid to non-controlling interests?

Practice question 3
The following information has been extracted from the consolidated financial statements of X Plc:
Year 4 Year 5
Rs. 000 Rs. 000
NCI dividends payable at 31 December 20 25
NCI share of group profits after tax for the year 270 300
NCI share in group net assets as at 31 December 600 630
Required
What figure will appear in the consolidated statement of cash flows for the year to 31 December
Year 5 in respect of non-controlling interests?

© Emile Woolf International 143 The Institute of Chartered Accountants of Pakistan

Advanced accounting and financial reporting

Practice question 4
The consolidated financial statements of Entity P for the year ended 31 March Year 6 showed the
following balances:
Non-controlling interests in the consolidated statement of financial position at 31 March Year 6 are
Rs. 6 million (Rs. 3.6 million at 31 March Year 5).
Non-controlling interests in the consolidated profit for the year ended 31 March Year 6 is Rs. 2
million.
During the year ended 31 March Year 6, the group acquired a new 75% subsidiary whose net assets
at the date of acquisition were Rs. 6.4 million.
On 31 March Year 6, the group revalued all its properties and the non-controlling interest in the
revaluation surplus was Rs. 1.5 million.
There were no dividends payable to non-controlling interests at the beginning or end of the year.
Required
What is the dividend paid to non-controlling interests that will be shown in the consolidated
statement of cash flows of Entity P for the year ended 31 March Year 6?

3.3 Dividends paid to non-controlling interests and foreign exchange adjustments

If there is a gain or loss on translation for a foreign subsidiary, the non-controlling interest has a
share of this exchange gain or loss. This means that the amount shown as the non-controlling
interest in the consolidated statement of financial position includes the non-controlling interest
share of any foreign exchange gains or is after deducting any foreign exchange losses.
A gain or loss arising from exchange rate differences is not a cash flow, but it changes the amount
for non-controlling interest in the consolidated statement of financial position. When the figures for
non-controlling interest in the opening and closing statements of financial position are used to
calculate dividend payments to non-controlling interests, we must therefore remove the effect of
exchange rate differences during the year.
The calculation of the dividends paid to the non-controlling interests should then be calculated as
follows:

Illustration: Dividends paid to NCI

Rs.
Non-controlling interest in group net assets at the beginning of the year X
Non-controlling interest in profits after tax for the year X
Add non-controlling interest share of foreign exchange gain (or subtract NCI
share of a loss) X/(X)
X
Dividends paid to non-controlling interests (as a balancing figure) X
Non-controlling interest in group net assets at the end of the year X

3.4 Associates (or JVs) and the group statement of cash flows
When a group has an interest in an associate entity, the consolidated statement of cash flows must
show the cash flows that occur between the associate (or JV) and the group. The consolidated
statement of cash flows shows the effect on the group’s cash position of transactions between the
group and its associate (or JV).

© Emile Woolf International 144 The Institute of Chartered Accountants of Pakistan

 Chapter 08: IAS 7: Statements of cash flows

The cash held by an associate (or JV) is not included in the group’s cash figure in the consolidated
statement of financial position. This is because the equity method of accounting does not add the
associate’s (or JV’s) cash to the cash of the holding company and subsidiaries. As far as cash
flows are concerned, the associate (or JV) is outside the group. (The same principles apply to other
investments accounted for under the equity method, such as joint ventures accounted for by the
equity method).
Share of profit (or loss) of an associate (or JV)
In the consolidated statement of profit or loss, the group profit includes the group’s share of the
profits of associates (or JVs). These profits are not a cash flow item. When the indirect method is
used to present the cash flows from operating activities, an adjustment is therefore needed to get
from ‘profit’ to ‘cash flow’.
 The group’s share of the profit of an associate (or JV) must be deducted from profit.
 The group’s share of the loss of an associate (or JV) must be added to profit.
Cash flows involving associates (or JVs)
The cash flows that might occur between a group and an associate (or JV), for inclusion in the
consolidated statement of cash flows are as follows:
 Investing activities
 cash paid to acquire shares in an associate (or JV) during the year
 cash received from the disposal of shares in an associate (or JV) during the year
 dividends received from an associate during the year.
 Financing activities
 cash paid as a new loan to or from an associate (or JV) during the year
 cash received as a repayment of a loan to or from an associate (or JV) during the
year.
Note that dividends received from an associate (or JV) are shown as cash flows from investing
activities; whereas dividends paid to non-controlling interests in subsidiaries are (usually) shown
as cash flows from financing activities.

3.5 Calculating dividends received from an associate (or JV)

In an examination, you may be required to calculate the dividends received from an associate (or
JV), using information in the opening and closing consolidated statements of financial position and
the consolidated statement of profit or loss. The technique is similar to the calculation of dividends
paid to non-controlling interests.

Illustration: Dividends received from an associate (or JV)

Rs.
Group investment in net assets of associate (or JV) at the beginning of the
year X
Group share of associate’s (or JV’s) profits before tax (X)
X
Dividends received from associate (or JV) in the year (X)
Group investment in net assets of associate (or JV) at the end of the year X

© Emile Woolf International 145 The Institute of Chartered Accountants of Pakistan

Advanced accounting and financial reporting

Example: Dividends received from an associate (or JV)

The following information has been extracted from the consolidated financial statements of P for
the year ended 31 December 20X7. The group has neither purchased nor disposed of any
investment during this period.
Group statement of profit or loss

Rs. 000
Group operating profit 1,468
Share of associate’s profit after tax 136
1,604
Tax on profit on ordinary activities:
Income taxes: group (648)
Profit on ordinary activities after tax 956
Group statement of financial position at 31 December
20X7 20X6
Rs. 000 Rs. 000
Investments in associates
Share of net assets 932 912

Required
(a) What figure should appear in the group statement of cash flows for the year to 31 December
20X7 for the associate?
(b) Under which heading would you expect this figure to appear in the group statement of cash
flows?

Answer

(a) Rs. 000

Group investment in net assets of associate at the beginning of the year 912
Group share of associate’s profits after tax 136
1,048
Dividends received from associate in the year (as a balancing figure) (116)
Group investment in net assets of associate at the end of the year 932

(b) The cash flow of Rs. 116,000 will be shown as a cash flow from investing activities in the
group statement of cash flows.

© Emile Woolf International 146 The Institute of Chartered Accountants of Pakistan

 Chapter 08: IAS 7: Statements of cash flows

Practice question 5
The following information has been extracted from the consolidated financial statements of P, a
holding company which prepares accounts to 31 December each year:
Consolidated statement of financial position (extract):

Year 4 Year 3
Rs. 000 Rs. 000
Investments in associated undertakings 932 912
Current assets
Dividend receivable from associate 96 58

Consolidated statement of profit or loss (extract):

Investments in associated undertakings Year 4

Rs. 000
Group operating profit 1,468
Share of operating profit of associate 136
1,604
Income taxes: (648)
Profit after tax 956

Required
Calculate the figure that will appear in the consolidated statement of cash flows for the year
to 31 December Year 4 in respect of dividend received from associates?

© Emile Woolf International 147 The Institute of Chartered Accountants of Pakistan

Advanced accounting and financial reporting

4 ACQUISITIONS AND DISPOSALS OF SUBSIDIARIES IN THE STATEMENT OF

CASH FLOWS

Section overview

 Acquisition of a subsidiary in the statement of cash flows

 Note to the statement of cash flows on acquisitions
 Avoiding double counting when a subsidiary has been acquired
 Disposal of a subsidiary in the statement of cash flows

4.1 Acquisition of a subsidiary in the statement of cash flows

When a subsidiary is acquired:
 the group gains control of the assets and liabilities of the subsidiary, which might include
some cash and cash equivalents, and
 the group pays for its share of the subsidiary, and the purchase consideration might consist
partly or entirely of cash.
In the group statement of cash flows, a single figure is shown (under the heading ‘Cash flows from
investing activities’) for the net effect of the cash flows from acquiring the subsidiary. This net effect
is:

Illustration: Cash paid for a subsidiary

Rs.
Cash element in the purchase consideration X
Minus: Cash assets of the subsidiary at the acquisition date (X)
Cash payment on acquisition of subsidiary, net of cash received X

This net cash payment is the amount shown in the group statement of cash flows.

Example: Cash paid for a subsidiary

Blue Group acquired 80% of the shares in Green Entity on 5 September 20X6, when the net assets
of Green Entity were Rs. 800,000, including Rs. 25,000 in cash and cash equivalents. The purchase
consideration was Rs. 700,000, consisting of Rs. 500,000 in new shares of Blue (the holding
company) and Rs. 200,000 in cash.
The cash flow shown in the group statement of cash flows for the year to 31 December 20X6 is:

Rs.
Cash element in the purchase consideration 200,000
Minus: Cash assets of the subsidiary at the acquisition date (25,000)
Cash payment on acquisition of subsidiary, net of cash received 175,000

Note that in the above example, even though only 80% of the shares in Green Entity have been
acquired, the full Rs. 25,000 of cash held by the subsidiary is brought into the group statement of
financial position at the acquisition date. The figure deducted from the cash in the purchase
consideration is therefore 100% of the subsidiary’s cash and cash equivalents acquired.

© Emile Woolf International 148 The Institute of Chartered Accountants of Pakistan

 Chapter 08: IAS 7: Statements of cash flows

4.2 Note to the statement of cash flows on acquisitions

In an examination, it is useful to prepare a statement summarising the cash flow effects of an
acquisition. This statement is actually required by IAS 7, and should be presented as a note to the
statement of cash flows.
The statement should be presented as follows:

Illustration: Note to the cash flow statements re acquisition

Rs.
Assets of the subsidiary at the acquisition date, at fair value X
Liabilities of the subsidiary at the acquisition date (X)
Net assets of the subsidiary at the acquisition date X
Minus non-controlling interest in the subsidiary at this date
(% Non-controlling interest × Net assets) (X)
Purchased goodwill X
Fair value of net assets acquired X

Satisfied by:
New shares in holding company X
Cash X
Purchase consideration X

The total purchase consideration equals the fair value of the net assets acquired.
The cash of the subsidiary at the acquisition date (C2) is then deducted from the cash paid (C1) to
arrive at the figure that appears in the statement of cash flows for the ‘Acquisition net of cash
received’

Example: Note to the cash flow statements re acquisition

A typical note to the statement of cash flows, using illustrative figures, might appear as follows for
a subsidiary in which 80% of the shares are acquired:

Rs. 000
Net assets acquired:
Cash (C2) 3
Trade receivables 85
Inventories 139
Property, plant and equipment 421
Trade payables (68)
Bank loan (100)
480
Non-controlling interest (20% × 480) (96)
384
Purchased goodwill 76
Fair value of net assets acquired 460

© Emile Woolf International 149 The Institute of Chartered Accountants of Pakistan

Advanced accounting and financial reporting

Satisfied by: Rs. 000

Issue of shares 152
Cash paid (C1) 308
460
Extract from statement of cash flows
Investing activities
Acquisition of subsidiary net of cash received (Rs. 308,000 – Rs. 3,000) Rs. 305,000
In the statement of cash flows itself, the cash payment on the acquisition of the subsidiary is not
Rs. 308,000, because the cash flow is shown as the payment minus the cash held by the subsidiary
at the acquisition date (which is cash brought into the group by acquiring the subsidiary).
In this example, the cash brought into the group on acquisition, as a part of the net assets of the
subsidiary, is Rs. 3,000.

4.3 Avoiding double counting when a subsidiary has been acquired

Cash flow information is often calculated from information in the opening and closing statements
of financial position.
If there is an acquisition during the year, it is important to make an adjustment to the calculation
for the assets or liabilities in the subsidiary that were acquired. Unless this adjustment is made, the
assets and liabilities in the subsidiary at the acquisition date will be counted twice and the
calculations will be incorrect.
An adjustment will be needed for every item of asset or liability acquired, except for cash and cash
equivalents.
Inventory, trade receivables, trade payables
When the indirect method is used to present cash flows from operating activities, the changes in
receivables, inventory and trade payables are shown as adjustments to the profit figure, to get to
a figure for cash flow.
When preparing a statement of cash flows for an individual company, the changes in these items
are calculated by calculating the difference in the figure in the closing statement of financial position
and the corresponding value in the opening statement of financial position.
However, when a subsidiary has been acquired, the working capital brought into the group
(receivables plus inventory minus trade payables of the acquired subsidiary) is paid for in the
purchase price to acquire the subsidiary. As we have seen, this is treated as a separate item in the
investing activities section of the statement of cash flows.
To avoid double counting of the effects of the working capital in the subsidiary at the acquisition
date, we need to deduct from the value in the closing statement of financial position, or add to the
value in the opening statement of financial position:
 the receivables in the net assets of the subsidiary acquired, as at the acquisition date
 the inventory in the net assets of the subsidiary acquired, as at the acquisition date, and
 the trade payables in the net assets of the subsidiary acquired, as at the acquisition date.
Example: Adjustment to calculation
D Group is preparing a group statement of cash flows for the year using the indirect method. In the
group opening and closing statements of financial position, inventories were:
At the beginning of the year Rs. 120,000
At the end of the year Rs. 190,000
During the year, the group acquired a 75% interest in a new subsidiary, Entity S, which had
inventories of Rs. 40,000 at the acquisition date.
Required
What figure should be shown in the group statement of cash flows as the adjustment for the
increase or decrease in inventories?

© Emile Woolf International 150 The Institute of Chartered Accountants of Pakistan

 Chapter 08: IAS 7: Statements of cash flows

Answer

Rs.
Group inventories at the beginning of the year 120,000
Add: Inventories acquired in the subsidiary 40,000
160,000
Adjustment for increase in inventories on acquisition of new subsidiary 30,000
Group inventories at the end of the year 190,000
Inventories have increased by Rs. 30,000 after allowing for the Rs. 40,000 of inventories brought
into the group when the subsidiary was purchased.
This would usually be shown as a working on the face of the answer as (Rs. 190,000  (120,000 +
40,000))

Purchases of non-current assets

When non-current assets are shown at their carrying amount (net book value) and a subsidiary
has been acquired during the year, purchases of non-current assets (assumed to be cash
payments) are calculated as follows.

Example: Cash paid to buy non-current assets

Rs.
Non-current assets at carrying amount, at the beginning of the year 240,000
Net book value of disposals of non-current assets during the year (30,000)
Depreciation charge for the year (40,000)
Cash paid to acquire non-current assets during the year (second
balancing figure) 55,000
Non-current assets acquired on acquisition of the subsidiary 65,000
Total additions (first balancing figure) 120,000
Non-current assets at carrying amount, at the end of the year 290,000

Other items
Similar principles can be applied to all other assets and liabilities to find the cash effect, for example
to calculate loan repayments and repayments of leasing obligations

Example: Tax paid

The Spot Group had the following items in its opening and closing group statements of financial
position at the beginning and at the end of 20X6:

At 1 January 20X6 At 31 December 20X6

Rs. 000 Rs. 000
Current tax payable 250 325
Deferred tax (liability) 136 165

The Spot Group acquired a 60% holding in a subsidiary, Entity B, on 7 May 20X6. The total tax
liability of Entity B at this date was Rs. 120,000. The total charge for taxation in the consolidated
statement of profit or loss of the Spot Group for the year to 31 December 20X6 was Rs. 950,000.
Required
What was the cash payment for taxation during the year, for inclusion on the group statement of
cash flows?

© Emile Woolf International 151 The Institute of Chartered Accountants of Pakistan

Advanced accounting and financial reporting

Answer
The tax liability in the subsidiary when it was acquired should be deducted from the closing tax
liability for the group (or added to the opening tax liability for the group) to avoid double counting.

Rs. 000
Group tax liability at the beginning of the year 386
Tax liability acquired in the subsidiary 120
Group tax charge in the year 950
1,456
Tax paid in the year (966)
Group tax at the end of the year (325 + 165) 490

Note
To calculate the tax payment for the year, you should take the entire tax charge at the beginning
and at the end of the year – both current tax and deferred tax.

Example: Dividends paid to non-controlling interest when a subsidiary has been acquired
The Spot Group had the following items in its opening and closing group statements of financial
position at the beginning and at the end of 20X6:

At 1 January 20X6 At 31 December 20X6

Rs. 000 Rs. 000
Non-controlling interest 350 415

The Spot Group acquired a 60% holding in a subsidiary, Entity B, on 7 May 20X6. The net assets of
Entity B at this date were Rs. 800,000 at fair value. The profit attributable to non-controlling
interests in the group’s statement of profit or loss for the year to 31 December 20X6 was Rs.
270,000.
Required
What dividends were paid to the non-controlling interests during the year to 31 December 20X6?

Answer
Again, to avoid double counting we need to:
a. deduct the non-controlling interest acquired from the value for non-controlling interest in the
closing consolidated statement of financial position, or
b. (as shown below) add the non-controlling interest acquired to the non-controlling interest in
the opening consolidated statement of financial position.
Rs. 000
Non-controlling interest at the beginning of the year 350
Non-controlling interest acquired in the subsidiary (40% × 800) 320
Non-controlling interest share of profits for the year 270
940
Dividends paid to non-controlling interest during the year (525)
Non-controlling interest at the end of the year 415
The cash outflow will be shown as a cash flow from financing activities.

© Emile Woolf International 152 The Institute of Chartered Accountants of Pakistan

 Chapter 08: IAS 7: Statements of cash flows

Example: Adjustment for the impairment of goodwill

The Spot Group had the following items in its opening and closing group statements of financial
position at the beginning and at the end of 20X6:

At 1 January 20X6 At 31 December 20X6

Rs. 000 Rs. 000

Goodwill 600 540

The Spot Group acquired a 60% holding in a subsidiary, Entity B, on 7 May 20X6. Purchased
goodwill arising on the acquisition of Entity B was Rs. 110,000. The Spot Group uses the indirect
method to present its group statement of cash flows.
Required
What is the impairment to goodwill for the year, and where would it appear in the group statement
of cash flows?

Answer
The impairment of goodwill is a non-cash item that reduces profit. When the indirect method is
used to present cash flows from operating activities, any impairment of assets during the year and
charged against profit must be added back to the profit figure (in the same way that depreciation
and amortisation charges are added back).
When a subsidiary is acquired during the year, the calculation of the impairment must allow for the
purchased goodwill in the newly-acquired subsidiary. An adjustment is needed to avoid double-
counting.

Rs. 000

Goodwill at the beginning of the year 600

Goodwill acquired in the subsidiary 110

710

Impairment (170)

Goodwill at the end of the year 540

4.4 Disposal of a subsidiary in the statement of cash flows

The procedures for reporting the cash effect of disposals of subsidiaries in a group statement of
cash flows are similar to those used for acquisitions, except that the process applies in reverse.
In the group statement of cash flows, the cash received from the disposal is the cash actually
received from the disposal, minus any cash in the subsidiary at the disposal date.
A note to the statement of cash flows should show the details of the disposal, including the cash
received from the sale minus the cash in the subsidiary at the disposal date.
The assets and liabilities disposed of, and the non-controlling interest leaves the group on the
disposal.

© Emile Woolf International 153 The Institute of Chartered Accountants of Pakistan

Advanced accounting and financial reporting

Example: Disposal
Entity D disposed of its 80% interest in the equity capital of Entity S for a cash sum of Rs. 550
million. The statement of financial position of Entity S at the date of disposal showed the following
balances:

Rs. 000

Tangible non current assets 500

Inventories 200

Trade receivables 300

Trade payables (200)

Taxation (including deferred taxation) (80)

Bank overdraft (320)

400

D acquired its interest in S at the date of incorporation of that company, so no goodwill arose.
Required
Prepare a statement summarising the effect of the disposal as a note to the consolidated
statement of cash flows.

Answer
Cash received from the sale of the shares in the subsidiary is Rs. 550,000. However, a note to the
statement of cash flows should present the details of the net assets disposed of, the proceeds from
the sale, and the profit or loss on disposal.
The profit or loss is the difference between the value of the net assets disposed of and the proceeds
from the sale. It is a balancing figure, in the same way that the purchased goodwill is the balancing
figure in a similar note to the statement of cash flows when a subsidiary has been acquired.
In this example, the subsidiary had a bank overdraft when it was disposed of. The cash in the
subsidiary at the date of disposal was therefore a negative amount. The group no longer has the
bank overdraft, which means that its cash flow position improved by selling off the subsidiary.
In the statement of cash flows itself, the cash proceeds from the disposal of the subsidiary (net of
cash ‘lost’) is the cash from the disposal proceeds plus the bank overdraft that is no longer in the
group (Rs. 550,000 + Rs. 320,000 = Rs. 870,000).
Rs. 000
Net assets disposed of:
Tangible non current assets 500
Inventories 200
Trade receivables 300
Trade payables (200)
Taxation (80)
Bank overdraft (320)
400

© Emile Woolf International 154 The Institute of Chartered Accountants of Pakistan

 Chapter 08: IAS 7: Statements of cash flows

Rs. 000

Non-controlling interest (20% × 400) (80)

320

Profit on disposal 230

Proceeds 550

Satisfied by:

Cash 550

Extract from the statement of cash flows

Investing activities
Sale of subsidiary (550 + 320) 870

To avoid double counting of the effects of the working capital in the subsidiary at the disposal date,
we need to deduct from the value in the opening statement of financial position, or add to the value
in the closing statement of financial position:
 the receivables in the net assets of the subsidiary sold as at the date of disposal;
 the inventory in the net assets of the subsidiary sold as at the date of disposal; and
 the trade payables in the net assets of the subsidiary sold as at the date of disposal.

Example: Disposal
Suppose that the group in the previous example uses the indirect method of computing the cash
flow from operating activities. Inventories were Rs. 1,600,000 in the opening group statement of
financial position at the beginning of the year and Rs. 1,500,000 in the closing group statement of
financial position.
Required
What figure in respect of inventories would be used as an adjustment in calculating the cash flows
from operating activities?

Answer

Rs. 000
Group inventories at the beginning of the year 1,600
Inventories disposed of in the subsidiary (200)
1,400
Adjustment for increase in inventories 100
Group inventories at the end of the year 1,500

© Emile Woolf International 155 The Institute of Chartered Accountants of Pakistan

Advanced accounting and financial reporting

5 REPORTING AND DISCLOSURES

Section overview

 Reporting
 Disclosures

5.1 Reporting

5.1.1 Cash flows from operating activities

An entity shall report cash flows from operating activities using either:
(a) the direct method, whereby major classes of gross cash receipts and gross cash
payments are disclosed; or
(b) the indirect method, whereby profit or loss is adjusted for the effects of transactions
of a non-cash nature, any deferrals or accruals of past or future operating cash
receipts or payments, and items of income or expense associated with investing or
financing cash flows.

5.1.2 Cash flows from investing and financing activities

An entity shall report separately major classes of gross cash receipts and gross cash
payments arising from investing and financing activities, except to the extent that cash
flows described in 5.1.3 are reported on a net basis.

5.1.3 Cash flows on a net basis

Cash flows arising from the following operating, investing or financing activities may be
reported on a net basis:
(a) cash receipts and payments on behalf of customers when the cash flows reflect
the activities of the customer rather than those of the entity; and
(b) cash receipts and payments for items in which the turnover is quick, the amounts
are large, and the maturities are short.
Examples of cash receipts and payments referred to in paragraph (a) above are:
(a) the acceptance and repayment of demand deposits of a bank;
(b) funds held for customers by an investment entity; and
(c) rents collected on behalf of, and paid over to, the owners of properties.
Examples of cash receipts and payments referred to in paragraph (b) above are advances made
for, and the repayment of:
(a) principal amounts relating to credit card customers;
(b) the purchase and sale of investments; and
(c) other short-term borrowings

5.2 Disclosures
i. Operating activities
The amount of cash flows arising from operating activities is a key indicator of the extent to
which the operations of the entity have generated sufficient cash flows to repay loans, maintain
the operating capability of the entity, pay dividends and make new investments without
recourse to external sources of financing.

© Emile Woolf International 156 The Institute of Chartered Accountants of Pakistan

 Chapter 08: IAS 7: Statements of cash flows

Examples of cash flows from operating activities are:

(a) cash receipts from the sale of goods and the rendering of services;
(b) cash receipts from royalties, fees, commissions and other revenue;
(c) cash payments to suppliers for goods and services;
(d) cash payments to and on behalf of employees;
(e) cash payments or refunds of income taxes unless they can be specifically identified with
financing and investing activities; and
(f) cash receipts and payments from contracts held for dealing or trading purposes.
ii. Investing activities
The separate disclosure of cash flows arising from investing activities is important because
the cash flows represent the extent to which expenditures have been made for resources
intended to generate future income and cash flows. Only expenditures that result in a
recognised asset in the statement of financial position are eligible for classification as investing
activities.
Examples of cash flows arising from investing activities are:
(a) cash payments to acquire property, plant and equipment, intangibles and other long-term
assets;
(b) cash receipts from sales of property, plant and equipment, intangibles and other long-term
assets; (c) cash payments to acquire equity or debt instruments of other entities and
interests in joint ventures;
(c) cash receipts from sales of equity or debt instruments of other entities and interests in joint
ventures;
(d) cash advances and loans made to other parties (other than financial institutions); and
(e) cash receipts from the repayment of advances and loans made to other parties (other than
financial institution)
iii. Financing activities
The separate disclosure of cash flows arising from financing activities is important because it
is useful in predicting claims on future cash flows by providers of capital to the entity.
Examples of cash flows arising from financing activities are:
(a) cash proceeds from issuing shares or other equity instruments;
(b) cash payments to owners to acquire or redeem the entity’s shares;
(c) cash proceeds from issuing debentures, loans, notes, bonds, mortgages and other short-
term or long-term borrowings;
(d) cash repayments of amounts borrowed; and
(e) cash payments by a lessee for the reduction of the outstanding liability relating to a lease.

© Emile Woolf International 157 The Institute of Chartered Accountants of Pakistan

Advanced accounting and financial reporting

SOLUTIONS TO PRACTICE QUESTIONS

Solution 1
Workings
Proceeds from new issue of shares Rs.
Share capital and share premium:
At the end of the year (500,000 + 615,000) 1,115,000
At the beginning of the year (400,000 + 275,000) 675,000
Proceeds from new issue of shares during the year 440,000

Repayment of loans
Loans repayable:
At the end of the year (520,000 + 55,000) 575,000
At the beginning of the year (600,000 + 80,000) 680,000
Repayment of loans during the year 105,000

Payment of dividends
Retained earnings at the beginning of the year 390,000
Profit after taxation for the year 420,000
810,000
Retained earnings at the end of the year (570,000)
Dividends paid during the year 240,000
Cash flows from financing activities can now be presented as follows.
Cash flows from financing activities Rs. Rs.
Proceeds from issue of shares 440,000
Repayment of loans (105,000)
Dividends paid to shareholders (240,000)
Net cash from financing activities 95,000

Solution 2
Dividend paid to non-controlling interest is as follows:
Rs. 000
Opening balances (320 + 1,380) 1,700
Share of profit for the year 240

1,940
Closing balances (200 + 1,560) (1,760)

Dividend paid 180

© Emile Woolf International 158 The Institute of Chartered Accountants of Pakistan

 Chapter 08: IAS 7: Statements of cash flows

Solution 3
Dividend paid to non-controlling interest is as follows:
Rs. 000
Balances at start of Year 5 (20+ 600) 620
Attributable to NCI in profit or loss for the year 300

920
Balances at end of Year 5 (25 + 630) 655

Cash paid to NCI (265)

Solution 4
Dividend paid to non-controlling interest is as follows:
Rs. m
Opening balance, NCI 3.6
NCI in profit for the year 2.0
Effect of acquisition: addition to NCI (25%  Rs. 6.4) 1.6
Revaluation surplus: addition to NCI 1.5

8.7
Closing balance, NCI 6.0

Dividend paid to NCI (balancing figure) (2.7)

Solution 5
Dividend from associate is as follows:
Rs. 000
Opening balances (912 + 58) 970
Share of profit after tax for the year 136

1,106
Closing balances (932 + 96) (1,028)

Dividend received 78

© Emile Woolf International 159 The Institute of Chartered Accountants of Pakistan

Advanced accounting and financial reporting

© Emile Woolf International 160 The Institute of Chartered Accountants of Pakistan

 Certified Finance and Accounting Professional

CHAPTER
Advanced accounting and financial reporting

Financial instruments:
Recognition and measurement

Contents
1 GAAP for financial instruments
2 Classification, reclassification and measurement
3 Impairment of financial assets
4 Embedded derivative
5 Derecognition of financial instruments
6 Hedge accounting
7 IFRIC 16: Hedges of a net investment in a foreign operation

© Emile Woolf International 161 The Institute of Chartered Accountants of Pakistan

Advanced accounting and financial reporting

1 GAAP FOR FINANCIAL INSTRUMENTS

Section overview

 Definitions
 Derivatives
 Using derivatives

1.1 Definitions
IAS 32, Financial Instruments: Presentation defines a financial instrument as a contract that gives
rise to both:
 A financial asset in one entity, and
 A financial liability or equity instrument in another entity.
It defines a financial asset as any asset that is:
 cash;
 An equity instrument of another entity;
 A contractual right:
 to receive cash or another financial asset from another entity; or
 to exchange financial assets or financial liabilities with another entity under conditions
that are potentially favorable to the entity
 a contract that will or may be settled in the entity's own equity instruments and is:
 a non-derivative for which the entity is or may be obliged to receive a variable number
of the entity's own equity instruments; or
 a derivative that will or may be settled other than by the exchange of a fixed amount
of cash or another financial asset for a fixed number of the entity's own equity.
It defines a financial liability as any liability that is a contractual obligation:
 To deliver cash or another financial asset to another entity; or
 To exchange financial assets or financial liabilities with another entity under conditions that
are potentially unfavorable to the entity; or
 a contract that will or may be settled in the entity's own equity instruments and is:
 a non-derivative for which the entity is or may be obliged to deliver a variable number
of the entity's own equity instruments; or
 a derivative that will or may be settled other than by the exchange of a fixed amount
of cash or another financial asset for a fixed number of the entity's own equity
instruments.
Financial instruments include:
 Cash
 Shares
 Loans
 Debentures
 Accounts receivable or accounts payable; and
 Financial derivatives and commodity derivatives.

© Emile Woolf International 162 The Institute of Chartered Accountants of Pakistan

 Chapter 09: Financial instruments: Recognition and measurement

1.2 Derivatives
IFRS 9, Financial Instruments defines a derivative as a financial instrument with all three of the
following characteristics:
 Its value changes in response to a specified underlying (interest rate, commodity price,
exchange rate etc.); and
 It requires no or little initial investment; and
 It is settled at a future date

Categories of derivatives
Derivatives can be classified into two broad categories:
 Forward arrangements (commit parties to a course of action)
 forward contracts
 futures
 swaps
 Options (gives the option buyer a choice over whether or not to exercise his rights under the
contract)
Forward contracts
A forward contract is a tailor-made (customised) contract to buy or sell a specified amount of a
specified item (commodity or financial item) on a specified date at a specified price.
A contract like this will require no initial outlay by the company (it has zero fair value at the date it
is entered into). Over the life of the contract, its fair value will depend on the spot exchange rates
and the time to the end of the contract.

Example: Forward contracts

A Pakistani company enters into a 6 month forward contract to buy US $100,000 at a rate of Rs.
160 = $1
This means that the Pakistani company will pay Rs. 16,000,000 to buy $100,000 in 6 months’
time.
This removes uncertainty for the Pakistani company.
A simple valuation of the forward can be made at any time over the life of the contract by
comparing the contracted rate to the spot rate.

Spot rate at date of valuation

Rs. 150 = $1 Rs. 170 = $1
Cost of $100,000 under forward contract Rs. 16,000,000 Rs. 16,000,000
Cost of $100,000 on open market Rs. 15,000,000 Rs. 17,000,000
Difference Rs. 1,000,000 Rs. 1,000,000
Pakistani company would recognise: a liability an asset

Note that this is a simplification. In practice the time to the end of the contract would need to be
built into the value. This is beyond the scope of the syllabus.

Futures
Futures are like forwards but are standardised in terms of amounts, date, currency, commodity etc.
This standardisation means that they can be traded. A company can enter into a futures contract
and then may make a gain or a loss on the market just like any other traded item.

© Emile Woolf International 163 The Institute of Chartered Accountants of Pakistan

Advanced accounting and financial reporting

If a company holds futures they might be an asset or a liability at any particular date.
Swaps
A swap is an agreement between parties to exchange cash flows related to an underlying
obligation. The most common type of swap is an interest rate swap. In an interest rate swap, two
parties agree to exchange interest payments on the same notional amount of principal, at regular
intervals over an agreed number of years.
One party might pay interest to the other party at a variable or floating rate, and in return the other
party may pay interest on the same principal amount at a fixed rate (a rate that is fixed by the swap
agreement).
A swap might be recorded as an asset or liability at any particular date. This depends on the
interaction between the amount that an entity has contracted to pay out and the amount that it is
entitled to receive.
Options
The holder of the option has entered into a contract that gives it the right but not the obligation to
buy (call option) or sell (put option) a specified amount of a specified commodity at a specified
price. An option differs from a forward arrangement. An option not only offers its buyer/holder the
choice to exercise his rights under the contract, but also the choice not to enforce the contract
terms.
The seller of the option must fulfil the terms of the contract, but only if the option holder chooses to
enforce it. Holding an option is therefore similar to an insurance policy: it is exercised if the market
price moves adversely. As the option holder has a privileged status – deciding whether or not to
enforce the contract terms – he is required to pay a sum of money (a premium) to the option seller.
This premium is paid when the option is arranged, and non-refundable if the holder later decides
not to exercise his rights under the option.
From the point of view of the holder the option will only ever be recorded as an asset. At initial
recognition this would be the amount of the premium. Subsequently the holder would only exercise
the option if it was beneficial to do so. Therefore, it could only ever be an asset.

1.3 Using derivatives

A company can enter into a transaction involving a derivative for one of two reasons:
 to speculate, and hope to make a profit from favourable movements in rates or prices; or
 to hedge against exposure to a particular risk
Speculation and the use of derivatives
Many derivatives are traded on exchanges, and so are easily available for buying and selling.
Entities can buy or sell derivatives in order to set up speculative positions, so that a profit will be
made from dealing in the derivatives provided that the market price of the ‘underlying item’ moves
favourably.
For example, forward contracts in cocoa could be purchased by a company that has no interest in
the cocoa itself, but just wants to gamble on future cocoa prices. The forward contracts would
probably be exchange-traded forward contracts, known as commodity (cocoa) futures.
Speculating in derivatives may expose entities to huge risks, if expectations do not come true and
the price of the underlying item moves the ‘wrong way’. In extreme cases this has led to financial
collapse of the company.
Hedging with derivatives
Derivatives can be used to obtain protection against exposure to the risk of an unfavourable
movement in the market price of an item, such as the price of a commodity, an interest rate or a
foreign exchange rate.

© Emile Woolf International 164 The Institute of Chartered Accountants of Pakistan

 Chapter 09: Financial instruments: Recognition and measurement

2 CLASSIFICATION, RECLASSIFICATION AND MEASUREMENT

Section overview

 Recognition of financial instruments

 Classification of financial assets
 Classification of financial liabilities
 Reclassification
 Measurement of financial instruments
 Regular way transactions
 Other measurement rules

2.1 Recognition of financial instruments

A financial asset or a financial liability should be recognised in the statement of financial position
when the reporting entity becomes a party to the contractual provisions of the instrument. The
recognition criteria of a financial asset or a liability is different from the recognition criteria for a
non-financial asset or liability. Usually an asset or liability is recognised when there is a probable
inflow or outflow of economic benefits.

2.2 Classification of financial assets

Classification determines how financial assets are accounted for and in particular, how they are
measured on an ongoing basis.
A company must classify financial assets as subsequently measured at:
 amortised cost;
 fair value through other comprehensive income; or
 fair value through profit or loss
This classification is made on the basis of both:
 the business model for managing the financial assets and
 the contractual cash flow characteristics of the financial asset.
Financial assets at amortised cost
A financial asset must be measured at amortised cost if both of the following conditions are met:
 the asset is held within a business model whose objective is to hold assets in order to collect
contractual cash flows; and
 the contractual terms of the financial asset give rise on specified dates to cash flows that are
solely payments of principal and interest on the principal amount outstanding.
Financial assets at fair value through other comprehensive income
A financial asset must be measured at fair value through other comprehensive income if both of
the following conditions are met:
 the financial asset is held within a business model whose objective is achieved by both
collecting contractual cash flows and selling financial assets and
 the contractual terms of the financial asset give rise on specified dates to cash flows that are
solely payments of principal and interest on the principal amount outstanding.
Financial assets at fair value through profit or loss
A financial asset must be measured at fair value through profit or loss unless it is measured at
amortised cost or at fair value through other comprehensive income.

© Emile Woolf International 165 The Institute of Chartered Accountants of Pakistan

Advanced accounting and financial reporting

2.3 Classification of financial liabilities

An entity shall classify all financial liabilities as subsequently measured at amortised cost with
specific exceptions including:
 financial liabilities at FVTPL including derivatives that are liabilities at the end of reporting
date; and
 financial liabilities that might arise when a financial asset is transferred but this transfer does
not satisfy the derecognition criteria.
 Financial guarantee contracts
 commitments to provide a loan at a below-market interest rate.
 contingent consideration recognised by an acquirer in a business combination to which IFRS
3 applies.
Reclassification of a financial liability after initial recognition is not allowed.
Irrevocable designation
A company is allowed to designate a financial liability as measured at fair value through profit or
loss. This designation can only be made if:
 it eliminates or significantly reduces a measurement or recognition inconsistency; or
 this would allow the company to reflect a documented risk management strategy.
Any such designation is irrevocable.
If a financial liability is measured at fair value any change due to the company’s own credit risk is
recognised in OCI (not P&L)
Summary of accounting of items measured at fair value

Category Examples
Financial asset at fair Whole fair value movement to profit or loss
value through profit or loss
Financial asset at fair Whole fair value movement to OCI
value through OCI Subsequent sale of the asset
Gain or loss on disposal calculated based on the carrying
amount of the asset at the date of disposal.
No reclassification of the amounts previously recognised in OCI
in respect of equity for which an irrevocable election has been
made.
Reclassification is still required for debt instruments measured at
fair value through OCI.
Financial liability at fair Change in fair value attributed to change in credit risk to OCI.
value through profit or loss Remaining change in fair value to profit or loss

Example: Equity investment

An equity investment is purchased for Rs. 30,000 plus 1% transaction costs on 1 January 20X6. It
is classified as at fair value through OCI.
At the end of the financial year (31 December) the investment is revalued to its fair value of Rs.
40,000.
On 11 December 20X7 it is sold for Rs. 50,000.
Required
Explain the accounting treatment for this investment.

© Emile Woolf International 166 The Institute of Chartered Accountants of Pakistan

 Chapter 09: Financial instruments: Recognition and measurement

Answer
1 January 20X6 The investment is recorded at Rs. 30,300. This is the cost plus the capitalised
transaction costs.
31 December 20X6 The investment is revalued to its fair value of Rs. 40,000.
The gain of Rs. 9,700 is included in other comprehensive income for the year.
11 December 20X7 The journal entry to record the disposal is as follows:

Dr Cr
Cash 50,000
Investment 40,000
Statement of profit or loss 10,000

2.4 Reclassification
Once the initial classification has been determined, the standard provides guidance on when an
entity should reclassify the financial instrument(s). It is pertinent to note that, if cash flows are
realised in a way that is different from the entity’s expectations at the date that management
assessed the business model, this fact does not give rise to a prior period error in the entity’s
financial statements (in accordance with IAS 8). Reclassifications should be accounted for
prospectively from the reclassification date.
Reclassifications should be made only when an entity changes its business model for managing
financial assets whereas, it is not allowed for financial liabilities. Changes to the business model
are expected to be infrequent; the change is determined by the entity’s senior management as a
result of external or internal changes and must be significant to the entity’s operations and should
be evident to external parties. A change in an entity’s business model will occur when an entity
either begins or ceases to perform an activity that is significant to its operations.
The following table shows the different reclassification scenarios and their accounting
consequences:

Original category New category Accounting impact

Amortized cost Fair value through Fair value is measured at reclassification date.
profit or loss Difference from carrying amount should be
recognised in profit or loss.
Fair value through Amortized cost Fair value at the reclassification date becomes its
profit or loss new gross carrying amount
Amortized cost Fair value through Fair value is measured at reclassification date.
other Difference from amortized cost should be
comprehensive recognized in OCI. Effective interest rate is not
income adjusted as a result of the reclassification.
Fair value through Amortized cost Fair value at the reclassification date becomes its
other new amortized cost carrying amount. Cumulative
comprehensive gain or loss in OCI is adjusted against the fair
income value of the financial asset at reclassification
date.
Fair value through Fair value through Fair value at reclassification date becomes its
profit or loss other new carrying amount. Effective interest rate is
comprehensive determined on the basis of the fair value at
income reclassification date.
Fair value through Fair value through Fair value at reclassification date becomes
other profit or loss carrying amount. Cumulative gain or loss on OCI
comprehensive is reclassified to profit or loss at reclassification
income date.

© Emile Woolf International 167 The Institute of Chartered Accountants of Pakistan

Advanced accounting and financial reporting

2.5 Measurement of financial instruments

Initial measurement
At initial recognition, an entity shall measure a financial asset at its fair value plus, in the case of a
financial asset not at fair value through profit or loss, transaction costs that are directly attributable
to the acquisition of the financial asset.
At initial recognition, an entity shall measure a financial liability at its fair value minus, in the case
of a financial liability not at fair value through profit or loss, transaction costs that are directly
attributable to the issue of the financial liability.
Transaction costs
Transaction costs are incremental costs that are directly attributable to the acquisition, issue or
disposal of a financial instrument. Examples of transaction costs are:
 fees and commissions paid to agents, advisers, brokers and dealers;
 levies by regulatory agencies and securities exchanges;
 transfer taxes and duties;
 credit assessment fees;
 registration charges and similar costs.
Cost that do not qualify as transaction costs are debt premiums or discounts, financing costs,
internal administration costs and holding costs.
For all financial instruments that are not measured at FVTPL the treatment of transaction costs is
made on an instrument-by-instrument basis and either increase (financial asset) or decrease
(financial liability) the amount initially recognised in the financial statements. For financial
intruments carried at FVTPL or all other transaction related costs that do not qualify as transaction
costs. are expensed as they are incurred.
Subsequent measurement
All financial assets are subsequently measured at amortized cost, fair value through other
comprehensive income (FVOCI) or fair value through profit or loss (FVPL) based on the business
model for managing the financial assets and their contractual cash flow characteristics. The
business model is determined by the entity’s key management personnel in the way that assets
are managed and their performance is reported to them.
Financial assets included within the FVOCI category are subsequently measured at fair value.
Movements in the carrying amount should be recorded through OCI, except for the recognition of
impairment gains or losses, interest revenue and foreign exchange gains and losses which are
recognized in profit and loss
FVPL is the residual category. Financial assets should be classified as FVPL if they do not meet
the criteria of FVOCI or amortized cost. Financial assets included within the FVPL category should
be measured at fair value with all changes recorded through profit or loss. Regardless of the
business model assessment, an entity can elect to classify a financial asset at FVPL if doing so
reduces or eliminates a measurement or recognition inconsistency (“accounting mismatch”).
Subsequent measurement Treatment of transaction cost
Fair value through profit or loss Written off as an expense in profit and loss.
Other methods (Amortised cost The transaction cost is capitalised and included in the initial
or fair value through OCI) cost of the financial instrument.

Held to maturity investments, loans and receivables and many financial liabilities are usually
measured at amortised cost after their initial recognition.
Amortised cost is calculated as follows for a financial asset:
i. amount initially recognised (initial cost of investment); plus
ii. interest income recognised (using the effective rate); less
iii. interest actually received (cash received).

© Emile Woolf International 168 The Institute of Chartered Accountants of Pakistan

 Chapter 09: Financial instruments: Recognition and measurement

Similarly, the amortised cost of a financial liability is calculated as:

i. amount initially recognised as a liability (initial cost); plus
ii. interest expense recognised (using the effective rate); less
iii. interest actually paid (cash paid).

Illustration: Amortised cost

Financial Financial
asset liability
Amount at initial recognition X X
Plus: Interest recognised using the effective rate:
as income X
as expense X
Less: repayments (X) (X)
Amortised cost X X

Interest expense is measured using the effective rate. This is the rate that matches the amount
loaned (borrowed) with the discounted future cash flows received (paid).
The effective rate is the discount rate that, when applied to the future interest and redemption cash
flows, gives an amount equal to the amount initially recognised for the financial asset or financial
liability. Thus, it results in a net present value of zero. It is the IRR of all cash flows associated with
lending or borrowing.
The interest recognised is calculated by applying the effective rate to the outstanding balance on
the bond at the beginning of the period. The interest recognised in profit and loss each year is not
necessarily the cash paid.
The outstanding balance at the end of a period is the opening balance plus the interest charge at
the effective rate, minus the actual interest payments in the period.

Example: Amortised cost (liability)

A company issues a bond (borrows).
The bond has an issue value of Rs. 1 million and pays a coupon rate of 5% interest for two years,
then 7% interest for two years (this is known as a stepped bond).
Interest is paid annually on the anniversary of the bond issue.
The bond will be redeemed at par after four years.
The effective rate for this bond is 5.942%
The amortised cost of the liability at the end of each year is calculated by constructing an
amortisation table as follows:

Amortised cost Interest at Amortised cost

Year Cash paid
brought forward 5.942% carried forward
1 1,000,000 59,424 (50,000) 1,009,424
2 1,009,424 59,983 (50,000) 1,019,407
3 1,019,407 60,577 (70,000) 1,009,984
4 1,009,984 60,016 (70,000) 1,000,000
240,000 240,000

© Emile Woolf International 169 The Institute of Chartered Accountants of Pakistan

Advanced accounting and financial reporting

The bond is initially recorded at cost (Rs. 1,000,000) and by the end of year 1 it has an amortised
cost of Rs. 1,009,424.
The difference is due to the difference in the interest expense recognised in the statement of profit
or loss (Rs. 59,424) and the interest actually paid (Rs. 50,000).
The total interest paid over the four years is Rs. 240,000. However, it is charged to the profit or loss
each year at the effective rate (5.942%) on the outstanding balance, not as the actual interest paid
on the bonds in cash each year.

The investor in the above bond would recognise a financial asset at amortised cost and recognise
interest income in the same amounts as above.

Practice question 1
X purchased a loan on 1 January 20X5 and classified it as measured at amortised cost.

Terms:
Nominal value Rs. 50 million
Coupon rate 10%
Term to maturity 3 years
Purchase price Rs. 48 million
Effective rate 11.67%
Required
Calculate the amortised cost of the bond and show the interest income for each year to maturity.

Practice question 2
A company issues Rs. 10 million of 6% bonds at a price of Rs. 100.50 for each Rs. 100
nominal value with issue costs of Rs. 50,000.
The bonds are redeemable after four years for Rs. 10,444,000.
The effective annual interest rate for this financial instrument is 7%.
Required
Calculate the amortised cost of the bond and show the interest expense for each year to
maturity.

2.6 Regular way transactions

In some markets for financial instruments, a contract might be contract entered into on one date
(trade date) is settled at a later date (settlement date) according to the rules of the market. For
example, trades on the Pakistan Stock Exchange are typically settled 2 days after the date of the
trade.
Such transactions are described as “regular way” transactions.

Definition: Regular way purchase or sale

A purchase or sale of a financial asset under a contract whose terms require delivery of the asset
within the time frame established generally by regulation or convention in the marketplace
concerned.

Basic rules
The basic rule of initial recognition was explained in paragraph 2.1 above as a financial asset or a
financial liability should be recognised in the statement of financial position when the reporting
entity becomes a party to the contractual provisions of the instrument.

© Emile Woolf International 170 The Institute of Chartered Accountants of Pakistan

 Chapter 09: Financial instruments: Recognition and measurement

The date on which an entity becomes a party to the contractual provisions of a financial asset
purchased under a regular way purchase is the trade date. However, IFRS 9 contains an exception
to this approach by which an entity can choose to account for a regular way purchase or sale of
financial assets using either trade date accounting or settlement date accounting.
The same method must be applied consistently for all purchases and sales of financial assets that
are classified in the same way.
Trade date accounting and settlement date accounting
The two methods differ in terms of the timing of recognition and derecognition of assets.

Trade date Settlement date

Meaning The trade date is the date that an entity The settlement date is the date that an
commits itself to purchase or sell an asset is delivered to or by an entity
asset.
Purchases Asset to be received and the liability to Asset recognised on the date it is received
pay for it are recognised on the trade by an entity.
date
Sales Derecogniton of an asset with Derecognition of an asset and recognition
recognition of receivable and gain or loss of any gain or loss on disposal on the day
arising occurs on the trade date that it is delivered by the entity.

Settlement date accounting issues

An entity must account for any change in the fair value of the asset between the trade date and
the settlement date in the same way as it accounts for the acquired asset. In other words any
change in value:
 is not recognised for assets measured at amortised cost; but
 is recognised in profit or loss for assets or other comprehensive income as appropriate for
financial assets measured at fair value.
Regular way purchase of financial asset

Example: Trade and settlement accounting for the purchase of an investment

An entity bought investment worth Rs. 1,000 on 27 December 2015.
The payment was to be made on 5th January 2016. The company classifies the investment as
FVTPL (held for trading).
The fair value of the asset on relevant dates was as follows:
Date Fair value
Trade date 27th December 2015 Rs. 1,000
Reporting date 31st December 2015 Rs. 1,005
Settlement date 5th January 2016 Rs. 1,015

The transaction is accounted for as follows using trade date accounting

27 December Debit Credit
Financial asset 1,000
Payable 1,000

© Emile Woolf International 171 The Institute of Chartered Accountants of Pakistan

Advanced accounting and financial reporting

31 December Debit Credit

Financial asset 5
Statement of profit or loss 5

5 January
Payable 1,000
Cash 1,000
The transaction is accounted for as follows using settlement date accounting
27 December: No entry

31 December Debit Credit

Receivable 5
Statement of profit or loss 5

5 January
Financial asset 1,015
Receivable 5
Statement of profit or loss 10
Cash 1,000

Regular way sale of financial asset

Example: Trade and settlement accounting for the purchase of an investment

An entity sold an investment with a carrying amount of Rs. 1,015 for Rs. 1,100 on 27 December
2015.
The payment was to be made on 5th January 2016. The company classifies the investment as
FVTPL (held for trading).
The fair value of the asset on relevant dates was as follows:

Date Fair value

Trade date 27th December 2015 Rs. 1,100
Reporting date 31st December 2015 Rs. 1,105
Settlement date 5th January 2016 Rs. 1,130

The transaction is accounted for as follows using trade date accounting

27 December Debit Credit
Receivable 1,100
Financial asset 1,015
Statement of profit or loss 85

31 December: No entry

© Emile Woolf International 172 The Institute of Chartered Accountants of Pakistan

 Chapter 09: Financial instruments: Recognition and measurement

5 January Debit Credit

Cash 1,100
Receivable 1,100
The transaction is accounted for as follows using settlement date accounting
27 December Debit Credit
Financial asset 85
Statement of profit or loss 85

31 December: No entry

5 January
Cash 1,100
Receivable 1,100
Note: Under both methods the risks and rewards are transferred on trade date. Therefore, an
entity does not book any gain or loss after trade date.

2.7 Other measurement rules

Option to designate a financial asset at fair value through profit or loss
A company may, at initial recognition, irrevocably designate a financial asset as measured at fair
value through profit or loss if doing so eliminates or significantly reduces a measurement or
recognition inconsistency (sometimes referred to as an ‘accounting mismatch’) that would
otherwise arise from measuring assets or liabilities or recognising the gains and losses on them
on different bases.
Equity instruments
Investments in equity are measured at fair value through profit or loss. However a company can
make an irrevocable election at initial recognition to measure an equity investment at fair value
through other comprehensive income as long as it is not held for trading.

© Emile Woolf International 173 The Institute of Chartered Accountants of Pakistan

Advanced accounting and financial reporting

3 IMPAIRMENT OF FINANCIAL ASSETS

Section overview

 Introduction
 Key definitions
 Simplified approach
 General approach
 Credit impairment

3.1 Introduction
Impairment of most non-current assets is covered by IAS 36. IAS 36 operates an incurred loss
model. This means that impairment is recognised only when an event has occurred which has
caused a fall in the recoverable amount as compared to carrying amount of an asset.
Impairment of financial instruments is dealt with by IFRS 9. IFRS 9 contains an expected loss
model. The expected loss model applies to all debt instruments (loans, receivables etc.) recorded
at amortised cost or at fair value through OCI. It also applies to contract assets (IFRS 15).
The aim of the expected loss model is that financial statements should reflect the deterioration or
improvement in the credit quality of financial instruments held by an entity. This is achieved by
recognising amounts for the expected credit loss associated with financial assets.
The rules look complex because they have been drafted to provide guidance to banks and similar
financial institutions on the recognition of credit losses on loans made. However, there is a
simplified regime that applies to other financial assets as specified in the standard (such as trade
receivables and lease receivables).

3.2 Key definitions

Credit loss
The difference between all contractual cash flows that are due to an entity in accordance with the
contract and all the cash flows that the entity expects to receive (i.e. all cash shortfalls), discounted
at the original effective interest rate)
Lifetime expected credit losses
The expected credit losses that result from all possible default events over the expected life of a
financial instrument.
12-month expected credit losses
The portion of lifetime expected credit losses that represent the expected credit losses that result
from default events on a financial instrument that are possible within the 12 months after the
reporting date

3.3 Simplified approach

This applies to trade receivables, contract assets and lease receivables. The approach involves
the recognition of lifetime expected losses for the relevant assets.
The following table summarises when the approach must or may be used.

Financial asset Simplified approach

Trade receivables or contract assets Must be used
(IFRS 15) that do not do not contain a
significant financing component
Trade receivables or contract assets that May be used if chosen as an accounting policy to be
contain a significant financing applied consistently to all trade receivables or
component contract assets.

© Emile Woolf International 174 The Institute of Chartered Accountants of Pakistan

 Chapter 09: Financial instruments: Recognition and measurement

Financial asset Simplified approach

It may be applied separately to trade receivables
and contract receivables.
Lease receivables May be used if chosen as an accounting policy to be
applied consistently.

Example:
X Limited has total trade receivables of Rs. 30,000,000.
The trade receivables do not have a significant financing component.
The loss allowance recognised at the end of the previous year was Rs. 500,000.
X Limited has constructed the following provision matrix to calculate expected lifetime losses of
trade receivables.

Number of days past due (overdue)

Current 1 to 30 31 to 60 61 to 90 More than 90

Default rate 0.3% 1.6% 3.6% 6.6% 10.6%

Required:
Calculate the lifetime expected credit loss, show the necessary double entry to record the loss and
state the amounts to be recognised in the statement of financial position.

Answer
The expected lifetime credit loss is measured as follows:

Gross carrying amount Lifetime expected

of trade receivables Default rate credit loss
Rs. % Rs.
Current 15,000,000 0.3 45,000
1 to 30 days 7,500,000 1.6 120,000
31 to 60 days 4,000,000 3.6 144,000
61 to 90 days 2,500,000 6.6 165,000
More than 90 1,000,000 10.6 106,000
30,000,000 580,000
X Limited must recognise a loss provision of Rs. 580,000.
The following double entry would be necessary to increase the opening loss provision to this
amount:
Debit Credit
Statement of profit or loss 80,000
Loss allowance 80,000
The trade receivables would be presented at an amount net of this allowance in
the statement of financial position (Rs. 30,000,000 - Rs. 580,000 = Rs.
29,420,000).

© Emile Woolf International 175 The Institute of Chartered Accountants of Pakistan

Advanced accounting and financial reporting

3.4 General approach

This approach must be applied to financial assets measured at amortised cost and financial assets
measured at fair value through OCI. The approach also applies to lease receivables and contract
assets unless the entity adopts the simplified approach described above. (Any impairment losses
on financial assets measured at fair value through profit and loss are automatically recognised in
profit or loss).
The objective of the requirements is to recognise lifetime expected credit losses for all financial
instruments for which there have been significant increases in credit risk since initial recognition
(whether assessed on an individual or collective basis) considering all reasonable and supportable
information.
Overview
For those financial assets to which the general approach applies, a loss allowance measured as
the 12-month expected credit losses is recognised at initial recognition.
The expected credit loss associated with the financial asset is then reviewed at each subsequent
reporting date. The amount of expected credit loss recognised as a loss allowance depends on the
extent of credit deterioration since initial recognition.
 If there is no significant increase in credit risk the loss allowance for that asset is remeasured
to the 12 month expected credit loss as at that date.
 If there is a significant increase in credit risk the loss allowance for that asset is remeasured
to the lifetime expected credit losses as at that date. This does not mean that the financial
asset is impaired. The entity still hopes to collect amounts due but the possibility of a loss
event has increased.
 If there is credit impairment, the financial asset is written down to its estimated recoverable
amount. The entity accepts that not all contractual cash flows will be collected and the asset
is impaired.
Credit impairment (the third bullet above) will be dealt with in a separate section below.
The first two bullets simply differ in terms of how the expected loss is measured. There is no
difference between the necessary double entry in each case.
Loss allowance for financial assets carried at amortised cost
Movement on the loss allowance is recognised in profit or loss.
The loss allowance balance is netted against the financial asset to which it relates on the face of
the statement of financial position.
NB: this is just for presentation only; the loss allowance does not reduce the carrying amount of
the financial asset in the double entry system.

Example:
1 January 20X1
X Limited has purchased a bond for Rs. 1,000,000.
The bond pays interest at 5% and is to be redeemed at par in 5 years’ time.
12 month expected credit loss = Rs. 25,000.
31 December 20X1
Interest is collected at its due date.
There is no significant change in credit risk.
12 month expected credit loss = Rs. 30,000.
Required
Show the double entries on initial recognition and at 31 December necessary to account for the
bond and the loss allowance.

© Emile Woolf International 176 The Institute of Chartered Accountants of Pakistan

 Chapter 09: Financial instruments: Recognition and measurement

Answer
1 January 20X1 Debit Credit
Financial asset at amortised cost 1,000,000
Cash 1,000,000
Being: Purchase of financial asset at amortised cost
Statement of profit or loss 25,000
Loss allowance 25,000
Being: Recognition of loss allowance on financial asset at amortised cost
31 December 20X1
Financial asset at amortised cost 50,000
Statement of profit or loss 50,000
Being: Accrual of interest income at the effective rate from financial asset at
amortised cost
Cash 50,000
Financial asset at amortised cost 50,000
Being: Receipt of interest income from financial asset at amortised cost
Statement of profit or loss 5,000
Loss allowance 5,000
Being: Recognition of movement on loss allowance.

Loss allowance for financial assets at fair value through OCI

Movement on the loss allowance is recognised in profit or loss but the loss allowance balance is
not netted against the financial asset to which it relates as this is carried at fair value. The loss
allowance is recognised in other comprehensive income.

Example:
1 January 20X1
X Limited has purchased a bond for Rs. 1,000,000.
The bond pays interest at 5% and is to be redeemed at par in 5 years’ time.
12 month expected credit loss = Rs. 25,000.
31 December 20X1
Interest is collected at its due date.
There is no significant change in credit risk.
The fair value of the bond is Rs. 940,000.
12 month expected credit loss = Rs. 30,000.
Required
Show the double entries on initial recognition and at 31 December necessary to account for the
bond and the loss allowance.

© Emile Woolf International 177 The Institute of Chartered Accountants of Pakistan

Advanced accounting and financial reporting

Answer
1 January 20X1 Debit Credit
Financial asset at amortised cost 1,000,000
Cash 1,000,000
Being: Purchase of financial asset at FVOCI
Statement of profit or loss 25,000
Other comprehensive income 25,000
Being: Recognition of loss allowance on financial asset at FVOCI.
31 December 20X1
Financial asset at amortised cost 50,000
Statement of profit or loss 50,000
Being: Accrual of interest income at the effective rate from financial asset at FVOCI.
Cash 50,000
Financial asset at FVOCI. 50,000
Being: Receipt of interest income from financial asset FVOCI.
Other comprehensive income 60,000
Financial asset at FVOCI. 60,000
Being: Fair value adjustment (loss) on financial asset at FVOCI.
Statement of profit or loss 5,000
Other comprehensive income 5,000
Being: Recognition of movement on loss allowance.
The following table summarises the above double entries. Credit entries are shown as figures in
brackets
Financial
Cash asset OCI P&L
Rs. 000 Rs. 000 Rs. 000 Rs. 000
1 January 20X1
Purchase of financial asset (1,000) 1,000
Recognition of loss allowance (25) 25

31 December 20X1
Interest accrual 50 (50)
Interest payment 50 (50)
1,000
Fair value adjustment (60) 60
Movement on loss allowance (5) 5
940 30

The balance in OCI for this asset is the fair value adjustment net of the loss allowance.

© Emile Woolf International 178 The Institute of Chartered Accountants of Pakistan

 Chapter 09: Financial instruments: Recognition and measurement

3.5 Credit impairment

A financial asset is credit-impaired when one or more events that have a detrimental impact on the
estimated future cash flows of that financial asset have occurred. Evidence that a financial asset
is credit-impaired include (but is not limited to) observable data about the following events:
 significant financial difficulty of the issuer or the borrower;
 a breach of contract, such as a default or past due event;
 the lender has granted to the borrower a concession for economic or contractual reasons
relating to the borrower’s financial difficulty that the lender would not otherwise have
considered:
 it is becoming probable that the borrower will enter bankruptcy or other financial
reorganisation;
 the disappearance of an active market for that financial asset because of financial difficulties;
or
 the purchase or origination of a financial asset at a deep discount that reflects the incurred
credit losses.
If an entity revises its estimates of receipts it must adjust the gross carrying amount of the financial
asset to reflect actual and revised estimated contractual cash flows. The financial asset must be
remeasured to the present value of estimated future cash flows from the asset discounted at the
original effective rate.

Example:
Company X invests in a bond.
The bond has an issue value of Rs. 1 million and pays a coupon rate of 5% interest for two years,
then 7% interest for two years (this known as a stepped bond).
Interest is paid annually on the anniversary of the bond issue.
The bond will be redeemed at par after four years.
The effective rate for this bond is 5.942%
At the end of the second year it becomes apparent that the issuer has financial difficulties and it
is estimated that Company X will only receive 60 paisa in the rupee of the future cash flows.
At the end of year 2 the amortised cost is:

Amortised cost Interest at Amortised cost

Year brought forward 5.942% Cash paid carried forward
1 1,000,000 59,424 (50,000) 1,009,424
2 1,009,424 59,983 (50,000) 1,019,407

The recoverable amount is calculated as follows:

Discount factor
Year Future cash flows (@5.942%)
3 70,000 @ 60% = 42,000 0.9439 39,644
4 1,070,000 @ 60% = 642,000 0.891 572,022
Recoverable amount 611,666
Carrying amount 1,019,407
Impairment 407,741

© Emile Woolf International 179 The Institute of Chartered Accountants of Pakistan

Advanced accounting and financial reporting

Note that the recoverable amount could have been calculated easily as 60% of the carrying
amount:
60% of 1,019,407 = 611,644 (22 difference due to rounding)
The impairment loss is charged to profit or loss taking into account the balance on the loss
allowance account already recognised for the asset.
Suppose in the above example there was a loss allowance of Rs. 100,000 recognised on the
asset before the impairment event.
The necessary double entries would be as follows:

Debit Credit
Statement of profit or loss 307,741
Loss allowance 100,000
Financial asset 407,741

Future revenue recognition

Interest is recognised in the future by applying the effective rate to the new amortised cost (after
the recognition of the impairment loss).

© Emile Woolf International 180 The Institute of Chartered Accountants of Pakistan

 Chapter 09: Financial instruments: Recognition and measurement

4 EMBEDDED DERIVATIVE
Section overview

 Embedded derivatives

4.1 Embedded derivatives

The treatment of embedded derivatives depends on whether the hybrid contract contains a host
that is an asset within the scope of IFRS 9.
Hybrid contains a host contract within the scope of IFRS 9
If the host contract is an asset within the scope of IFRS 9 the normal rules of classification and
accounting apply.
The contractual cash flows of the financial asset are assessed in their entirety, and the asset as a
whole is measured at FVTPL if any of its cash flows do not represent payments of principal and
interest.

Example:
ABC Ltd. buys Rs.10 million XYZ Ltd. convertible bond with a maturity period of 10 years. This
convertible bond pays 2% interest rate p.a. The bond can be converted to 1 million shares of XYZ
Ltd. shares which are publicly traded. The ABC Ltd. must determine the value of the conversion
option which is embedded in the debt instrument and then there is a need for separate accounting
of it as a derivative. To account for it as a derivative the fair value estimation was done using option
pricing model which showed the fair value of the bond stood at Rs.500,000.
ABC Ltd. would pass the following journal entry to account for it:

Debit Credit
---------------- Amount in Rupees --------------------
Bond 10,000,000
Conversion option (at fair value) `500,000
Cash 10,000,000
Discount on bond 500,000

© Emile Woolf International 181 The Institute of Chartered Accountants of Pakistan

Advanced accounting and financial reporting

5 DERECOGNITION OF FINANCIAL INSTRUMENTS

Section overview

 Derecognition of financial assets

 Derecognition of financial liabilities
 IFRIC 19: Extinguishing financial liabilities with equity instruments

5.1 Derecognition of a financial asset

Derecognition is the removal of a previously recognised financial asset or financial liability from an
entity’s statement of financial position.
Most transactions involving derecognition of a financial asset are straightforward. However,
financial assets may be subject to complicated transactions where some of the risks and rewards
that attach to an asset are retained but some are passed on.
It means is that a financial asset is derecognised if one of three combinations of circumstances
occurs:
 the contractual rights to the cash flows from the financial asset expire; or
 the financial asset is transferred and substantially all of the risks and rewards of ownership
pass to the transferee; or
 the financial asset is transferred, substantially all of the risks and rewards of ownership are
neither transferred nor retained but control of the asset has been lost.

© Emile Woolf International 182 The Institute of Chartered Accountants of Pakistan

 Chapter 09: Financial instruments: Recognition and measurement

Derecognition of financial assets

The following flow chart illustrates the evaluation of whether and to what extent a financial asset is
dereognised.

© Emile Woolf International 183 The Institute of Chartered Accountants of Pakistan

Advanced accounting and financial reporting

Most transactions being considered involve the receipt of cash.

 Transactions where the asset is derecognised may lead to the recognition of a profit or loss
on disposal.
 Transactions where the asset is not derecognised lead to the recognition of a liability for the
cash received.

Example: Derecognition
ABC collects Rs. 10,000 that it is owed by a customer.
1 Have the contractual rights to cash flows of the financial asset expired?
Yes – Derecognise the asset
Dr Cash Rs. 10,000
Cr Receivable Rs. 10,000

Example: Derecognition
ABC sells Rs. 100,000 of its accounts receivables to a factor and receives an 80% advance
immediately. The factor charges a fee of Rs. 8,000 for the service.
The debts are factored without recourse and a balancing payment of Rs. 12,000 will be paid by
the factor 30 days after the receivables are factored.

Answer
1 Have the contractual rights to cash flows of the financial asset expired?
No – ask the next question
2 Has the asset been transferred to another party?
Yes (for 80% of it)
3 Have substantially all of the risks and rewards of ownership passed?
The receivables are factored without recourse so ABC has passed on the risks and rewards
of ownership.
ABC must derecognise the asset transferred.
Dr Cash Rs. 80,000
Cr Receivables Rs. 80,000
In addition ABC has given part of the receivable to the factor as a fee:
Dr P&L Rs. 8,000
Cr Receivables Rs. 8,000

Example: Derecognition
ABC sells Rs. 100,000 of its accounts receivables to a factor and receives an 80% advance
immediately. The factor charges a fee of Rs. 8,000 for the service.
The debts are factored with recourse and a further advance of 12% will be received by the seller if
the customer pays on time.

© Emile Woolf International 184 The Institute of Chartered Accountants of Pakistan

 Chapter 09: Financial instruments: Recognition and measurement

Answer
1 Have the contractual rights to cash flows of the financial asset expired?
No – ask the next question
2 Has the asset been transferred to another party?
Yes (for 80% of it)

3 Have substantially all of the risks and rewards of ownership passed?

The debt is factored with recourse so the bad debt risk stays with ABC. In addition, ABC has
access to future rewards as further sums are receivable if the customers pay on time.
As ABC has kept the future risks and rewards relating to the Rs. 80,000, this element of
the receivable is not derecognised.
Dr Cash Rs. 80,000
Cr Liability Rs. 80,000
Being receipt of cash from factor – This liability is reduced as the factor collects the cash.
Dr Liability Rs. X
Cr Receivable Rs. X
In addition ABC has given part of the receivable to the factor as a fee:
Dr P&L Rs. 8,000
Cr Receivables Rs. 8,000

Risks and rewards are neither passed nor retained

Deals involving financial assets can be quite complex exposing the parties to different shares of
risks and rewards associated with an asset. This means that it might not be possible to decide
whether the risks and rewards have substantially passed or not. In such cases the entity that has
“sold” will derecognise the asset only if control has been lost. This depends on whether the
transferee has the practical ability to sell the asset. If so then the asset is derecognised by the
transferor.
For example, an entity may not sell a financial asset but instead gives a counter party an “option”
to buy it. In such a case, the passing or retaining of risks and rewards depends on whether the
counter party will exercise the option or not. In other words the risks and rewards are neither
passed nor retained.
Another example involves repo (sale and repurchase transactions).
Repo transactions
Under a repo transaction, a company sells an asset with a condition that the same asset will be
bought at a later date on fixed price.
Such a transaction is, in substance, a loan arrangement rather than a sale. It is a method of an
entity providing collateral for a loan. The rules in IFRS 9 result in the transaction being treated as
a financing transaction with the recognition of a liability as the conditions for derecognition of
financial assets are not fulfilled.

© Emile Woolf International 185 The Institute of Chartered Accountants of Pakistan

Advanced accounting and financial reporting

Example: Repo
X Limited sold an investment (Rs. 100,000 15% bond carried at amortised cost of Rs. 103,000)
for Rs. 110,000 and simultaneously entered into a contract to buy the same investment back in
two years with a repurchase rate of 20%
The investment had an effective yield (IRR) of 18%.
This transaction should be reflected in Co. A’s books as follows:
Transaction date Debit Credit
Cash 110,000
Repo liability 110,000
The investment is not derecognised so X Limited recognises income on the investment at its
effective yield.
However, it is the counter party not X Limited that receives the cash so X Limited shows this
as a reduction in the repo liability.
Year 1 Debit Credit
Repo liability (15%  Rs.100,000) 15,000
Investment 3,540
Interest income (18%  Rs.103,000) 18,540

Interest expense (20%  Rs.110,000) 22,000

Repo liability 22,000

The movement on the investment and the repo liability is as follows (with credits
being shown in brackets):
Repo
Investment liability Cash Profit or loss
Balance b/f 103,000
(110,000) 110,000
Year 1:
Income 3,540 15,000 (18,540)
Interest expense (22,000) 22,000
Balance b/f 106,540 (117,000)

Year 2 Debit Credit

Repo liability 15,000
Investment 4,177
Interest income Cr 19,177

Interest expense (at the repo rate of 20%) 23,400

Repo liability 23,400

Repayment of repo liability (repurchase of investment)

Cash 125,400
Repo liability 125,400

© Emile Woolf International 186 The Institute of Chartered Accountants of Pakistan

 Chapter 09: Financial instruments: Recognition and measurement

Repo
Investment liability Cash Profit or loss
Balance b/f 106,540 (117,000)
Year 2:
Income 4,177 15,000 (19,177)
Interest expense (23,400) 23,400
Repurchase of
investment 125,400 (125,400)
Balance b/f 110,717 

5.2 Derecognition of financial liabilities

A financial liability (or a part of a financial liability) is derecognised when, and only when, it is
extinguished.
This is when the obligation specified in the contract is discharged or cancelled or expires.
Modification (restructuring) of a liability
An entity facing liquidity problems might ask a lender to modify the terms of a loan. This might
involve the lender changing the timing of payments (restructuring) the liability, waiving part of the
loan (thus reducing the amount payable) or a combination of both.
The accounting treatment for a modification depends on whether the terms of the loan after the
modification are substantially different from those of the original loan.
Modification with substantially different terms
If the new terms are identified as a substantial modification, the original loan is extinguished and a
new financial liability is recognised in its place with any gain or loss recognised in the statement of
profit or loss.
The new liability is recognised at its fair value in accordance with the normal rules of recognition of
financial instruments. This is found by discounting the revised future payments at the market rate
of interest that applies to such cash flows.

Example: Substantial modification of a liability

X Limited had a loan of Rs. 1,000 repayable in 4 years on which it paid interest at 10%.
The carrying amount of the liability was Rs. 1000.
The effective rate of the liability is 10%. (The IRR of any loan carried and redeemed at par is the
same as the coupon rate).
X Limited faced liquidity problems and the lender agreed to restructure the loan. Under this new
arrangement X limited was to make a single payment of Rs. 1,200 at the end of Year 4 instead of
the originally scheduled payments.
The market rate at the time of restructuring was 12%.
This would be accounted for as follows:
Step 1: Identify whether the modification is substantial or not Rs.
Carrying amount of the original loan 1,000
PV of the revised cash flows at the original effective rate (Rs. 1,200  1/1.14) 820
Difference 180
As a percentage of the original carrying amount (180/1,000  100) 18%
Conclusion:
The terms of the original loan have been substantially modified

© Emile Woolf International 187 The Institute of Chartered Accountants of Pakistan

Advanced accounting and financial reporting

Step 2: Account for the substantial modification Dr Cr

Extinguishment of original loan 1,000
Recognition of new loan (working) 763
Gain on the modification 237
Working: Fair value of new loan on initial recognition
(Rs. 1,200  1/1.124) = Rs. 763

Modification with terms that are not substantially different

A liability is not derecognised when the terms of a modification are not substantially different from
those of the original loan.
Instead, a new effective rate is calculated based on the carrying amount at the date of the
modification (adjusted for any associated modification fee) and the revised cash flows.

Example: Modification with terms that are not substantially different

X Limited had a liability of Rs. 2,000,000 repayable in 5 years on which it paid interest at 15%.
The carrying amount of the liability was Rs. 2,000,000.
The effective rate of the liability is 15%.
X Limited faced liquidity problems and the lender agreed to restructure the loan. Under this new
arrangement X limited was to make a single payment of Rs. 3,500,000 at the end of Year 5 instead
of the originally scheduled payments.
A fee of Rs. 100,000 was paid for the revision.
This would be accounted for as follows:
Step 1: Identify whether the modification is substantial or not Rs.
Carrying amount of the original loan 2,000,000
PV of the revised cash flows at the original effective rate
(Rs. 100,000 + (Rs. 3,500,000  1/1.155)) 1,840,119
Difference 159,881
As a percentage of the original carrying amount (159,881/2,000,000  100) 8%
Conclusion:
The terms of the original loan have not been substantially modified

Step 2: Calculate the new effective yield

Discount Present Discount Present
factor at value at factor at value at
Year Cash flow 10% 10% 15% 15%
0 (2,000) 1.000 (2,000) 1,000 (2,000)
0 100 1.000 100 1,000 100
5 3,500 0.621 2,173 0.497 1,740
NPV 273 (160)

Using NPVA
IRR = A% + ( ) × (B − A)%
NPVA − NPVB
273
IRR = 10% + ( ) × 5% = 13%
433
Interest is recognised at 13% instead of 15% from the date of the modification.

© Emile Woolf International 188 The Institute of Chartered Accountants of Pakistan

 Chapter 09: Financial instruments: Recognition and measurement

5.3 IFRIC 19: Extinguishing financial liabilities with equity instruments

Background
The terms of a liability might be renegotiated such that the lender (creditor) accepts equity
instruments as payment instead of cash. (The lender accepts a debt to equity swap).
IFRIC 19 sets out how an entity that issues equity instruments to extinguish all or part of a financial
liability should account for the transaction.
Scope
IFRIC 19 does not address accounting by the creditor.
The following transactions are scoped out of IFRIC 19:
 Transactions involving the creditor in its capacity as an existing shareholder (e.g. a rights
issue);
 Transactions between businesses under common control both before and after the
transaction. This allows companies within a group to account for exchange of debt for equity
instruments in a corporate reconstruction without regard to the rules in this interpretation.
 Extinguishing a financial liability by issuing equity instruments in accordance with the original
terms of the liability (e.g. convertible instruments).
Issues addressed
How should an entity initially measure the equity instruments issued?
How should the entity account for any difference between the carrying amount of the liability
extinguished and the initially measured equity instruments?
Consensus: Are the equity instruments “consideration paid”
The issue of equity instruments is “consideration paid” to extinguish all or part of a financial liability.
This leads to the derecognition of the liability.
Consensus: Initial measurement of equity instruments issued
Equity instruments issued must be initially measured at the fair value of those instruments. If the
fair value cannot be reliably measured then the fair value of the liability extinguished is used
instead.
Consensus: Accounting for the difference
The difference between the carrying amount of the liability extinguished and the consideration paid
(fair value of equity instruments issued) must be recognised in profit or loss. A separate line item
or disclosure in the notes is required.
If only a part of the financial liability is extinguished the part of the consideration allocated to the
remaining liability must form part of the assessment as to whether the remaining liability has been
substantially modified.

Example: Accounting for the difference

Entity X has in issue Rs. 50m 6% loan stock.
It negotiates with the lenders an extinguishment of the debt by the issue of equity instruments
with a fair value of Rs. 48m.
The double entry is as follows:
Debit Credit
Financial liability Rs. 50m
Equity Rs. 48m
Profit on extinguishment Rs. 2m

© Emile Woolf International 189 The Institute of Chartered Accountants of Pakistan

Advanced accounting and financial reporting

Example: IFRIC 19
1 January Year 1
X Limited borrowed Rs. 25,000,000 on the following terms:

Face value Rs. 25,000,000

Term of loan 10 years
Redemption value Rs. 30,000,000
Coupon rate 12%
Effective rate (IRR) 13.08150%

31 December Year 5
X Limited has fallen into financial difficulties and renegotiated the terms of the loan.
The lender has agreed to extinguish 55% of the loan in exchange for an equity stake in X Limited.
The terms of the agreement were as follows:

Shares to be issued by X Limited to lender Rs. 17,000,000

Of which:
Consideration for extinguishment of 55% of the loan Rs. 16,500,000
Shares issued for modification (restructuring fee) Rs. 500,000
Market rate at the date of arrangement 14.5%

Under the terms of the modification no interest will be paid on the remaining amount and a sum
of Rs. 30,000,000 will be paid at the end of the term. (5 Years from now)
Required
Show how X Limited must account for the modification to the terms of the loan.

Step 1: Estimate the carrying amount of the liability at the date of the arrangement

Year Opening Interest Payment Closing

1 25,000,000 3,270,375 (3,000,000) 25,270,375
2 25,270,375 3,305,744 (3,000,000) 25,576,119
3 25,576,119 3,345,740 (3,000,000) 25,921,860
4 25,921,860 3,390,968 (3,000,000) 26,312,828
5 26,312,828 3,442,113 (3,000,000) 26,754,940
Extinguished (55%) 14,715,217
Retained (45%) 12,039,723

Step 2: Accounting for extinguishment of the 55%

Debit Credit

Statement of profit or loss 1,784,783

Financial liability Dr 14,715,214

Equity 16,500,000

© Emile Woolf International 190 The Institute of Chartered Accountants of Pakistan

 Chapter 09: Financial instruments: Recognition and measurement

Step 3 Accounting for portion retained (45%)

Step 3a: Identify whether the modification is substantial or not

Rs.
Carrying amount of the original loan 12,039,723
PV of the revised cash flows at the original effective rate
Rs. 500,000 + (30,000,000  1/(1.1308150)5) 16,724,206
Difference 4,684,483
As a percentage of the original carrying amount
(4,684,483/12,039,723  100) 39%

Conclusion:
The terms of the original loan have been substantially modified

Step 3b: Account for the substantial modification

Debit Credit
Original liability 12,039,723
Statement of profit or loss 3,704,097
Equity 500,000
New liability (working) 15,243,820
Working: Fair value of new loan on initial recognition
(Rs. 30,000,000  1/1.1455) = Rs. 15,243,820

© Emile Woolf International 191 The Institute of Chartered Accountants of Pakistan

Advanced accounting and financial reporting

6 HEDGE ACCOUNTING
Section overview

 What is hedging?
 Definitions
 The principles of hedge accounting
 Fair value hedge
 Cash flow hedge
 Cash flow hedge – basis adjustment
 Hedges of a net investment in a foreign operation

6.1 What is hedging?

Hedging is the process of entering into a transaction in order to reduce risk. Companies may use
derivatives to establish ‘positions’, so that gains or losses from holding the position in derivatives
will offset losses or gains on the related item that is being hedged.

Example:
A UK company has a liability to pay a US supplier $200,000 in three months’ time.
The company is exposed to the risk that the US dollar will increase in value against the British
pound in the next three months, so that the payment in dollars will become more expensive (in
pounds).
A hedge can be created for this exposure to foreign exchange risk by making a forward contract
to buy $200,000 in three months’ time, at a rate of exchange that is fixed now by the contract.
This is an example of hedging: the exposure to risk has been removed by the forward contract.

The logic of accounting for hedging should be that if a position is hedged, then any gains on the
underlying instrument that are reported in profit and loss should be offset by matching losses on
the hedging position in derivatives, which should also be reported in profit or loss.
Similarly, any losses on the underlying instrument that are reported in profit or loss should be offset
by matching gains on the hedging position in derivatives, which should also be reported in profit or
loss.
However, without special rules to account for hedging, the financial statements may not reflect the
offsetting of the risk and the economic reality of hedging.

6.2 Definitions
Hedged item

Definition
A hedged item is an asset, liability, firm commitment, highly probable forecast transaction or net
investment in a foreign operation that exposes the entity to risk of changes in fair value or future
cash flows and is designated as being hedged.

Hedges of net items cannot qualify for hedge accounting. Suppose a company whose functional
currency was rupees had a €100 asset and an €80 liability. This company would have a foreign
exchange risk exposure on €20. In practice a company might hedge this €20 position. This cannot
qualify for hedge accounting.

© Emile Woolf International 192 The Institute of Chartered Accountants of Pakistan

 Chapter 09: Financial instruments: Recognition and measurement

However, this is not the case for non-financial items which must be hedged for foreign exchange
risk or their total risk. For example, a jet fuel manufacturer might hedge the crude oil cost
component of its production costs.
Hedging instrument

Definition
A hedging instrument is a designated derivative or (for a hedge of the risk of changes in foreign
currency exchange rates only) a designated non-derivative financial asset or non-derivative
financial liability whose fair value or cash flows are expected to offset changes in the fair value or
cash flows of a designated hedged item.

Hedge accounting is not allowed for hedges where non derivative financial assets and liabilities
are used as hedging instruments except for hedges of foreign exchange risk.
Hedge accounting is only allowed for hedges involving derivatives external to the entity. Therefore,
if a member of a group takes a derivative position with another member of the group in order to
hedge a risk it may use hedge accounting in its own financial statements. This hedge accounting
must be removed on consolidation as then the derivative is not external.
Hedge effectiveness

Definition
Hedge effectiveness is the degree to which changes in the fair value or cash flows of the hedged
item that are attributable to a hedged risk are offset by changes in the fair value or cash flows of
the hedging instrument.

IFRS 9 does not specify methods of measuring effectiveness but does require that it be measured
on every reporting date (at least). Whatever method is used must be documented and in place
before hedge accounting is allowed.

6.3 The principles of hedge accounting

Hedge accounting provides special rules that allow the matching of the gain or loss on the
derivatives position with the loss or gain on the hedged item. This reduces volatility in the statement
of financial position and the statement of profit or loss, and so is very attractive to the preparers of
accounts.
The special rules for accounting for hedging can only be used where very stringent conditions are
met:
 Hedge effectiveness requirements (prospective):
 Economic relationship exists
 Credit risk does not dominate value changes
 Designated hedge ratio is consistent with risk management strategy.
 Formal documentation must be prepared to describe
 risk management objective and strategy;
 hedging instrument;
 hedged item;
 nature of risk being hedged;
 hedge effectiveness;

© Emile Woolf International 193 The Institute of Chartered Accountants of Pakistan

Advanced accounting and financial reporting

Hedge accounting models

Where the conditions for using hedge accounting are met, the method of hedge accounting to be
used depends on the type of hedge.
IFRS 9 identifies three types of hedging relationship:
 fair value hedges
 cash flow hedges; and
 hedges of a net investment in a foreign entity (accounted for as a cash flow hedge).
6.4 Fair value hedge
A fair value hedge is a hedge against the risk of a change in the fair value of an asset or liability.
For example, oil held in inventory could be hedged with an oil forward contract to hedge the
exposure to a risk of a fall in oil sales prices. Or the risk of a change in the fair value of a fixed rate
debt owed by a company could be hedged using an interest rate swap.
Accounting treatment of fair value hedges
Accounting for a fair value hedge is as follows:
 The gain or loss on the hedging instrument (the derivative) is taken to profit or loss, as
normal.
 The carrying amount of the hedged item is adjusted by the loss or gain on the hedged item
attributable to the hedged risk with the other side of the entry recognised in profit or loss.

Example: Fair value hedge

Entity X holds an inventory of 100 barrels of oil at a cost of $70 a barrel.
30th September 20X1: Oil is trading at $100 a barrel. Entity X decides to hedge the fair value of
its oil inventory by entering into a 12 m forward contract to sell the oil at $100 per barrel.
31st December 20X1: Oil is trading at $90 per barrel.
Required
Assuming that the hedge has been properly documented explain the accounting treatment for
this hedge (ignore time value).

Answer
Hedging instrument (gain)
The forward contract gives Entity X the right to sell oil at $100 per barrel but it is only worth $90
per barrel. This represents a gain of $10 per barrel
Dr Derivative asset (100 barrels @ $10) $1,000
Cr P&L $1,000
Hedged item (loss)
The fair value of oil has fallen by $10 per barrel. The carrying amount of the inventory is adjusted
by this amount.
Dr P&L $1,000
Cr Inventory $1,000
Note that the hedged item is not fair valued. Its carrying amount is adjusted by the change in its
fair value.

© Emile Woolf International 194 The Institute of Chartered Accountants of Pakistan

 Chapter 09: Financial instruments: Recognition and measurement

Summary
Debit/(credit)
Derivative
Inventory (asset) P&L
30th September 20X1 10,000
31st December 20X1:
Fair value change
Derivative 1,000 (1,000)
Inventory (1,000) 1,000
9,000 1,000 Nil

6.5 Cash flow hedge

A cash flow hedge is a hedge against the risk of changes in cash flows relating to a recognised
asset or liability or an anticipated purchase or sale. For example, floating rate debt issued by a
company might be hedged using an interest rate swap to manage increases in interest rates. Or
future US dollar sales of airline seats by a Pakistani company might be hedged by a US$/Rs.
forward contracts to manage changes in exchange rates. These are hedges relating to future cash
flows from interest payments or foreign exchange receipts.
Accounting treatment of cash flow hedges
Accounting for a cash flow hedge is as follows:
 The change in the fair value of the hedging instrument is analysed into ‘effective’ and
‘ineffective’ elements.
 The ‘effective’ portion is recognised in other comprehensive income (directly in equity).
 The ‘ineffective’ portion is recognised in profit or loss.
 The amount recognised in other comprehensive income is subsequently released to the
profit or loss as a reclassification adjustment in the same period as the hedged forecast cash
flows affect profit or loss.

Example: Cash flow hedge

X SA is a French company
It expects to sell $1,000 of airline seats for cash in six months’ time.
The current spot rate is €1 = $1.
It sells the future dollar receipts forward to fix the amount to be received in euros and to provide a
hedge against the risk of a fall in the value of the dollar against the euro.
At inception (30 September 20X1)
At inception, the anticipated future sale is not recorded in the accounts, and the derivative (the
forward contract) has an initial value of zero.
Reporting date (31 December 20X1)
The dollar has weakened with the following results:
a. The derivative is an asset with a fair value of €80.
b. The change in expected cash flows in euros from the forecast seat sales has fallen by €75
(€1,000 to €925).
Effectiveness:
The hedge is highly effective, because the change in the value of the forward contract (+ €80)
closely matches the change in the value of the forecast sales receipts (– €75).

© Emile Woolf International 195 The Institute of Chartered Accountants of Pakistan

Advanced accounting and financial reporting

The hedge is 93.75% effective (75/80). Alternatively, this could be expressed as 106.67% (80/75).
It is within the range 80% to 125%.
Accounting:
The gain on the derivative of €80 must be split into ‘effective’ and ‘ineffective’ elements.
The ‘effective’ gain is the amount of the gain that matches the fall in value in the hedged item. In
this example, this is €75.
The ‘ineffective’ gain is the difference (€80 - €75 = €5).
The effective gain is recognised in other comprehensive income and accumulated in an equity
reserve.
The ineffective element of €5 is reported as a gain in profit or loss for the period.
Dr Cr
Derivative 80
Equity reserve 75
Profit or loss 5
31 March 20X2 (At settlement)
The forward contract is settled with a gain of €103. This is €23 more than expected at the last
reporting date. The amount must be recognised with the effective element being taken to OCI and
the ineffective element recognised in P&L.
The airline seats are sold, but the proceeds in euros are €905. This is €20 less than the €925
estimated at the last reporting date.
The further gain on the derivative must be split into effective and ineffective elements:
a. Effective = €20 (€ 925 – € 905, which is the loss on the euro receipts)
b. Ineffective = €3 (the balance, €23 – €20).
Dr Cr
Derivative 23
Equity reserve 20
Profit or loss 3
Accounting on settlement
The income from the sales is €905.
The ‘effective’ gains on the derivative held in the equity reserve are released to profit or loss as a
reclassification adjustment in other comprehensive income.
The release of the €95 to profit or loss means that the total income from the seat sales and the
effective hedged gains is €1,000. This was the amount of income that was ‘hedged’ by the original
forward contract.
Summary: Debit /(credit)
Derivative Profit or
Cash OCI
(asset) loss
Previous period 80 (75) (5)
Current period:
Fair value change 23 (20) (3)
Sale of seats 905 (905)
Reclassification adjustment 95 (95)
Settle forward contract 103 (103)
1,008 0 0 (1,008)
The statement of profit or loss includes €1,000 revenue that the company ‘locked into’ with the
hedging position, plus the gain of €8 (€5 + €3) on the ineffective part of the hedge (= the speculative
element of the derivative).

© Emile Woolf International 196 The Institute of Chartered Accountants of Pakistan

 Chapter 09: Financial instruments: Recognition and measurement

6.6 Cash flow hedge – Basis adjustment

A cash flow hedged transaction might be the future purchase of a non-financial asset.

Example: Cash flow hedge – Basis adjustment

Entity X is based in the UK and has a December year end. Its functional currency is sterling (GBP)
Entity X forecasts the purchase of a machine from a US supplier and will be paid for in dollars
(USD). The purchase is expected to occur on 1 st January 20X3.
It is now 30th September 20X2. The cost of the machine is $15,000. The exchange rate is $1.5=£1
giving a cost to Entity X of £10,000.
Entity X hedges the exchange risk be entering into a forward contract for $15,000 @ $1.5=£1. This
is designated as a cash flow hedge and accounted for accordingly.
1st January 20X3
Entity X buys the machine for $15,000. The exchange rate is $1.47=£1 giving a cost to Entity X of
£10,200.
A gain on the forward contract of £200 has been recognised through OCI by this date. This means
that there is a credit balance of £200 in the cash flow hedge reserve in equity.
This must be released to profit as the hedged transaction impacts the profit and loss account. The
hedged transaction impacts the profit and loss account as the asset is depreciated.

There are two ways of doing this.

Approach one

Debit /(credit)

OCI (equity Profit or

Machine reserve) loss)

1 January 20X3 10,200 (200)

31 December 20X3:

Depreciation (say 10 years) (1,020) 1,020

Transfer from equity:

reclassification adjustment 20 (20)

Charge for the year 1,000

Balance carried forward 9,180 (180)

The amounts recognised on the statement of financial position net at £10,000 on initial recognition
(10,200 – 200). This is because Entity X was able to lock in the rate of $1.5=£1 for the purchase
of the machine. The accounting treatment results in a net expense in the P&L of £1,000
(£10,000/10 years).
When a hedged forecast transaction results in the recognition of a non-financial asset (or liability)
an entity is allowed to net off the amount deferred in equity against the initial amount recognised
for the asset.
This is known as a “basis adjustment”.

© Emile Woolf International 197 The Institute of Chartered Accountants of Pakistan

Advanced accounting and financial reporting

Approach two

Debit /(credit)

Equity
reserve Profit or
Machine (via OCI) loss (P&L)

1 January 20X3 10,200 (200)

Basis adjustment (200) 200

Carrying amount on initial

recognition 10,000 nil

31 December 20X3:

Depreciation (say 10 years) (1,000) 1,000

Charge for the year 1,000

Balance carried forward 9,000 nil

This is only allowed for non-financial assets and liabilities. Approach one must be used for
financial assets and liabilities.

6.7 Hedges of a net investment in a foreign operation

A later chapter explains the accounting treatment, for consolidation purposes, of an investment in
a foreign subsidiary or other foreign operation.
The net assets of the foreign subsidiary are translated at the end of each financial year, and any
foreign exchange differences are recognised in other comprehensive income (until the foreign
subsidiary is disposed of, when the cumulative profit or loss is then reclassified from ‘equity’ to
profit or loss).
This is accounted for as a cash flow hedge.

© Emile Woolf International 198 The Institute of Chartered Accountants of Pakistan

 Chapter 09: Financial instruments: Recognition and measurement

7 IFRIC 16: HEDGES OF A NET INVESTMENT IN A FOREIGN OPERATION

Section overview

 Introduction
 Consensus – Location of hedging instrument
 Consensus – Nature of hedged risk

7.1 Introduction
Scope
IFRIC 16 applies to hedges of foreign currency risk in a net investment in a foreign operation where
an entity wishes to qualify for hedge accounting under IFRS 9
Background
IFRS 9 allows hedge accounting of hedges of a net investment in a foreign operation (subject to
satisfying the hedge accounting criteria).

Definitions
Foreign operation: an entity that is a subsidiary, associate, joint venture or branch of a reporting
entity, the activities of which are based or conducted in a country or currency other than those of
the reporting entity.
Net investment in a foreign operation: the amount of the reporting entity’s interest in the net
assets of that operation.

Therefore, hedge accounting of the foreign exchange risk of the net investment in a foreign
operation only applies in financial statements where the interest in the foreign operation is included
as the investing company’s share of its net assets. This means for example that hedge accounting
in respect of the exchange risk associated with an investment in a foreign subsidiary is only allowed
in the consolidated financial statements.
Where there is such a designated hedging relationship the effective part of the gain or loss on the
hedging instrument is recognised in other comprehensive income and accumulated with the foreign
exchange differences arising on translation of the results and financial position of the foreign
operation.
Investments in a foreign operation may be held directly or indirectly
IFRIC 16 addresses the following three issues:
 Where the hedging instrument should be held within a group.
 The nature of the hedged risk and the amount of a hedged item for which a hedging
relationship may be designated?
 The amounts that should be reclassified from equity to profit or loss as on disposal of the
foreign operation?

7.2 Consensus – Location of hedging instrument

The hedging instrument may be held by any entity within the group.

7.3 Consensus – Nature of hedged risk

Hedge accounting may be applied only to foreign exchange differences arising between the
functional currency of the foreign operation and that of any parent entity but not to hedges of forex
differences between functional currency of a subsidiary to presentation currency of a parent.

© Emile Woolf International 199 The Institute of Chartered Accountants of Pakistan

Advanced accounting and financial reporting

Example:
The following group comprises a parent and 3 100% owned subsidiaries.
The functional currency of each member of the group is shown in brackets.

Further information:
Subsidiary A has external borrowings of $300,000.
Subsidiary C has net assets of $300,000.
Designation of hedged risk
In its consolidated financial statements, the parent designates Subsidiary A’s borrowing as a hedge
of the €/$ exchange risk of its net investment in C.
Accounting
The exchange difference on the retranslation of the net assets of C is recognised in OCI and
accumulated in the currency translation reserve. (IAS 21).
(In effect this is a translation of dollars to pounds and then the pounds into euro).
The exchange gain or loss on the external borrowing is recognised in OCI and accumulated in the
currency translation reserve. (IFRS 9).
(In effect this is a translation of dollars to yen and then the yen into euro).

Example:
The following group comprises a parent and 3 100% owned subsidiaries.
The functional currency of each member of the group is shown in brackets.

Further information:
Subsidiary A has external borrowings of $300,000.
Subsidiary C has net assets of $300,000.
Designation of hedged risk
In its consolidated financial statements, the parent designates Subsidiary A’s borrowing as a hedge
of the £/$ exchange risk between subsidiary B and C.

© Emile Woolf International 200 The Institute of Chartered Accountants of Pakistan

 Chapter 09: Financial instruments: Recognition and measurement

Accounting
The exchange difference on the retranslation of the net assets of C is recognised in OCI and
accumulated in the currency translation reserve. (IAS 21).
(In effect this is a translation of dollars to pounds and then the pounds into euro).
The recognition of the exchange gain or loss arising on the external borrowing is quite complicated.
Dollars to pounds: Any gain or loss recognised in OCI (applying IAS39/IFRS 9 – this is the offset of
the hedged risk above).
Pounds to yen: Any gain or loss recognised in P&L (applying IAS 21 for individual company
transactions).
Yen to dollars: Any gain or loss recognised in OCI (IAS 21 for translation differences arising on
consolidation).

The hedged item may be an amount of net assets equal to or less than the carrying amount of the
net assets of the foreign operation.
A forex exposure arising from a net investment in a foreign operation may qualify for hedge
accounting only once in consolidated financial statements.

© Emile Woolf International 201 The Institute of Chartered Accountants of Pakistan

Advanced accounting and financial reporting

SOLUTIONS TO PRACTICE QUESTIONS

Solution 1
The amount recognised as income in profit or loss each year is based on the effective rate of return, but
the cash actually received is based on the coupon rate of 10%.
The difference is treated as an adjustment to the carrying value of the investment in the statement of
financial position, which is the amortised cost of the asset.
This is calculated as follows:

Year Asset value Interest at Asset value carried

Cash paid
brought forward 11.67% forward

20X5 48.00m 5.60m (5m) 48.06m

20X6 48.60m 5.65m (5m) 49.25m

20X7 49.25m 5.75m (5m) 50.00m

17m 15m

Solution 2
The initial liability is (Rs. 10 million × 100.50/100) – Rs. 50,000 = Rs. 10,000,000.

Liability at start Finance Liability at end

Interest paid
of year charge at 7% of year

Rs. Rs. Rs. Rs.

Year 1 10,000,000 700,000 (600,000) 10,100,000

Year 2 10,100,000 707,000 (600,000) 10,207,000

Year 3 10,207,000 714,490 (600,000) 10,321,490

Year 4 10,321,490 722,510 (600,000) 10,444,000

2,844,000 2,400,000

The final interest payment of Rs. 722,510 contains a rounding adjustment of Rs. 6.
Note that the difference between the interest charged and the interest paid is because the final payment
of the redemption proceeds has not been shown. This contains a redemption premium of Rs. 444,000
which has already been recognised as an expense by the year end.

© Emile Woolf International 202 The Institute of Chartered Accountants of Pakistan

 Certified Finance and Accounting Professional

10

CHAPTER
Advanced accounting and financial reporting

Financial instruments:
Presentation and disclosure

Contents
1 IAS 32: Presentation
2 Interpretations
3 IFRS 7: Disclosure

© Emile Woolf International 203 The Institute of Chartered Accountants of Pakistan

Advanced accounting and financial reporting

1 IAS 32: PRESENTATION

Section overview

 Liability or equity?
 Preference shares: debt or equity?
 Compound instruments
 Transactions in own equity
 Offsetting
 Distributable profit

1.1 Liability or equity?

Financial instruments issued by a company must be classified as either liabilities or equity. This
classification should be based on the substance of the contract, rather than the legal form.
A financial liability is any liability where the issuer has a contractual obligation:
 To deliver cash or another financial asset to another entity, or
 To exchange financial instruments with another entity on potentially unfavourable terms.
The owner of an equity instrument is entitled to receive a dividend, but the company does not have
a contractual obligation to make the payment. So equity does not meet the above definition of a
financial liability.
An equity instrument is defined as any contract that offers the residual interest in the assets of the
company after deducting all of the liabilities.
Returns on financial instruments
Returns on financial instruments are reported differently, depending on whether the instrument is
a liability or equity. The classification of the financial instrument determines the treatment of the
interest, dividends, gains and losses.
 Interest expense, dividend payments, gains and losses relating to a financial liability are
recognised in the statement of profit or loss.
 Distributions to equity holders are debited to equity and shown in the statement of changes
in equity.

1.2 Preference shares: debt or equity?

Preference shares are shares that are entitled to a payment of their dividend, usually a fixed
amount each year, before the ordinary shareholders can be paid any dividend or that rank ahead
of ordinary shares for any distribution of net assets in the event of a winding up of the company.
Preference shares include the following types:
 Redeemable preference shares are those that the entity has an obligation to buy back (or
the right to buy back) at a future date.
 Irredeemable (perpetual) preference shares are those that will not be bought back at any
time in the future.
 convertible preference shares are those that are convertible at a future date into another
financial instrument, usually into ordinary equity shares of the entity.
Classification of preference shares
Depending on their characteristics, preference shares issued by a company might be classified as:
 equity; or
 a financial liability of the company; or

© Emile Woolf International 204 The Institute of Chartered Accountants of Pakistan

 Chapter 10: Financial instruments: Presentation and disclosure

 a compound financial instrument containing elements of both financial liability and equity.
IAS 32 states (in a guidance note) that the key factor for classifying preference shares is the extent
to which the entity is obliged to make future payments to the preference shareholders.
 Redeemable preference shares.
 Redemption is mandatory: Since the issuing entity will be required to redeem the
shares, there is an obligation. The shares are a financial liability.
 Redemption at the choice of the holder: Since the issuing entity does not have an
unconditional right to avoid delivering cash or another financial asset there is an
obligation. The shares are a financial liability.
 Redemption at the choice of the issuer: The issuing entity has an unconditional right
to avoid delivering cash or another financial asset there is no obligation. The shares
are equity.
 Irredeemable non-cumulative preference shares should be treated as equity, because the
entity has no obligation to the shareholders that the shareholders have any right to enforce.

1.3 Compound instruments

A compound instrument is a financial instrument, issued by a company that cannot be classified
as simply a liability or as equity, because it contains elements of both debt and equity. An example
of a compound instrument is a convertible bond. The company issues a bond that can be converted
into equity in the future or redeemed for cash. Initially, it is a liability, but it has a call option on the
company’s equity embedded within it.
Typically, a convertible bond pays a rate of interest that is lower than the market rate for a non-
convertible bond (a ‘straight bond’) with the same risk profile. This is because the terms of the
conversion normally allow the bondholder to convert the bond into shares at a rate that is lower
than the market price.
Split accounting for compound instruments
On initial recognition of compound instrument, the credit entry for the financial instrument must be
split into the two component parts, equity and liability.
When convertible bonds are issued they are shown in the statement of financial position partly as
debt finance and partly as equity finance. The question is how to determine the amount of the issue
price that is debt and the amount that is equity.
The method to use is to calculate the equity element as the residual after determining the present
value of the debt element:
 The present value of the interest payments and the redemption value of the convertible is
found using a market interest rate for similar debt finance which is not convertible (normally
a higher interest rate as there is no conversion element).
 Compare this present value to the proceeds of the bond issue to find the residual equity
element.
 Any transaction costs incurred by issuing the instrument should be allocated to each
component, the liability and equity, according to the split in value above.
Comment on the measurement of the debt element
The process starts by deriving a fair value for the liability, on the assumption that the bond has no
conversion rights, and is a ‘straight’ fixed rate bond that will be redeemed at par at maturity.
If the company had sold a bond with identical features but with no conversion rights, how much
could it have been sold for? To answer this question, it is necessary to recognise that the fair value
of a bond is simply the present value of the future cash flows that the bond will generate, discounted
at the market rate of interest, which in the following example is 8%.

© Emile Woolf International 205 The Institute of Chartered Accountants of Pakistan

Advanced accounting and financial reporting

Example: Convertible bond

A company issues Rs. 10 million of 6% convertible bonds at par on 1 January 20X1.
The bonds are redeemable at par after four years or can be converted at any time up to that date
into shares with a nominal value of Rs. 2,000,000.
The market rate of interest for similar debt which is not convertible is 8%.
The bonds should be recorded in the statement of financial position at the date of issue as follows:

Step 1: Measure the liability component first by discounting the interest payments and the
amount that would be paid on redemption (if not converted) at the prevailing market interest rate
of 8%.

31 December Cash flow DF (8%) Rs.

20X1 to 20X4
Interest: 10,000,000  6% 600,000 3.312 1,987,200
20X4:
Repayment of principle 10,000,000 0.735 7,350,000
Value of debt element 9,337,200

Step 2: Compare the value of the debt element to the cash raised. The difference is the equity
element.

Total proceeds 10,000,000

Value of equity element (residual) 662,800
The initial double entry to recognise the bond would be as follows:
Dr Cr
Cash 10,000,000
Liability 9,337,200
Equity 662,800

The liability component is measured at amortised cost in the usual way at each subsequent
reporting date.

Example (continued): Subsequent measurement of the debt element of the convertible bond

Cash flow
Amortised cost Interest at (interest
at start of the effective rate actually paid Amortised cost
year (8%) at 6%) at year end
20X1 9,337,200 746,976 (600,000) 9,484,176
20X2 9,484,176 758,734 (600,000) 9,642,910
20X3 9,642,910 771,433 (600,000) 9,814,343
20X4 9,814,343 785,557 (600,000) 10,000,000

Note that the final interest expense of Rs. 785,557 includes a rounding adjustment of Rs. 510).
There is no guidance on the subsequent accounting treatment of the equity element. One approach
would be to retain it as a separate component of equity and then release it to retained earnings
when the bond is paid or converted.

© Emile Woolf International 206 The Institute of Chartered Accountants of Pakistan

 Chapter 10: Financial instruments: Presentation and disclosure

Example (continued): Double entry on repayment or conversion of the bond.

At 31 December 20X4 the bond will either be paid or converted. Possible double entries in each
case are as follows:
If the bond is repaid
Dr Cr
Liability 10,000,000
Cash 10,000,000
and:
Equity component 662,800
Retained earnings 662,800

If the bond is converted:

Dr Cr
Liability 10,000,000
Share capital 2,000,000
Share premium 8,000,000
and:
Equity component 662,800
Retained earnings 662,800

Practice question 1
A company issued a convertible bond for Rs. 2,000,000 on 1 January 20X5.
The bond is to be redeemed on 31 December 20X7 (3 years after issue). The bond holders
can take cash or shares with a nominal value of Rs. 1,200,000 on this date.
The bond pays interest at 5% but the market rate of interest for similar risk bonds without
the conversion feature was 9% at the date of issue.
Required
a) Calculate the liability and equity components of the bond on initial recognition.
b) Construct the necessary journal on initial recognition.
c) Construct an amortisation table to show how the liability component would be
measured over the life of the bond.
d) Construct the journal to reflect the possible conversion of the bonds to shares on 31
December 20X7.

1.4 Transactions in own equity

A company may reacquire its own shares. Such shares are called treasury shares. The company
might then hold on to the shares until it uses them for a particular purpose, such as awarding
shares to employees in a share grant scheme. The accounting treatment of treasury shares is that
they should be deducted from equity.
Any gain or loss on transactions involving treasury shares is recognised directly in equity, and
should not be reported in the statement of profit or loss and other comprehensive income.
IAS 32 requires that the amount of treasury shares held should be disclosed separately, either:
 on the face of the statement of financial position as a deduction from share capital, or
 offset against share capital and disclosed in the notes to the accounts.

© Emile Woolf International 207 The Institute of Chartered Accountants of Pakistan

Advanced accounting and financial reporting

1.5 Offsetting
Offsetting an asset and a liability and presenting a net amount on the face of the statement of
financial position can result in a loss of information to the users. IAS 1 prohibits offset unless
required or permitted by an IFRS.
The idea is that offset should only be allowed if it reflects the substance of the transactions or
balances.
IAS 32 adds more detail to this guidance in respect of offsetting financial assets and liabilities.
IAS 32 requires the presentation of financial assets and financial liabilities in a way that reflects the
company’s future cash flows from collecting the cash from the asset and paying the cash on the
liability. It limits a company’s ability to offset a financial asset and a financial liability to those
instances when the cash flows will occur at the same time.
The IAS 32 rule is that a financial asset and a financial liability must be offset and shown net in the
statement of financial position when and only when an entity:
 Currently has a legal right to set off the amounts; and
 Intends either to settle the amounts net, or to realise (sell) the asset and settle the liability
simultaneously.
In order for a legal right of set off to be current it must not be contingent on a future event.
Furthermore, it must be legally enforceable in all of the following circumstances:
 The normal course of business;
 The event of default;
 The event of insolvency or bankruptcy of the entity and all of the counterparties
Note: The existence of a legal right to set off a cash balance in one account with an overdraft in
another is insufficient for offsetting to be allowed. The company must additionally show intent to
settle the balances net, and this is likely to be rare in practice. Consequently, cash balances in the
bank and bank overdrafts are usually reported separately in the statement of financial position, and
not ‘netted off’ against each other.
Many companies adopting IFRS for the first time find that they have net amounts in the statement
of financial position under their old GAAP that have to be shown as a separate financial asset and
financial liability under IFRS. The net position is described as being “grossed up”.

1.6 Distributable profit

Dividends are declared, in respect of a period, in a general meeting on the recommendation of the
directors.
A dividend cannot exceed the amount recommended by the directors.
Dividends are payable only out of the distributable profits of the company (but not profit on the sale
of capital assets).
Dividends are paid by individual entities. When a group announces that it is paying a dividend it is
actually the parent company that is making the payment.

© Emile Woolf International 208 The Institute of Chartered Accountants of Pakistan

 Chapter 10: Financial instruments: Presentation and disclosure

Example: Group distributions

P acquired 80% of S on 1 January 20X1 for Rs. 230,000.
The retained profits of S were Rs. 100,000 at that date and are Rs. 300,000 at the current year
end.
P has retained profits of Rs. 400,000 at the current year end.
The consolidated retained profits are as follows:

Consolidated retained profits: Rs.

All of P’s retained profits 400,000
P’s share of the post-acquisition retained profits of S (80%
of (300,000  100,000)) 160,000
560,000

The maximum distribution that can be made by the group (i.e. as a dividend paid to P’s
shareholders) is Rs. 400,000.
The share of post-acquisition retained profits of S are contained in a separate legal entity and are
not available for distribution by the parent.
If S were to pay a dividend, 80% would pass to P and hence become available for P to pay out to
its owners. (The remaining 20% would be owned by the NCI).

© Emile Woolf International 209 The Institute of Chartered Accountants of Pakistan

Advanced accounting and financial reporting

2 INTERPRETATIONS
Section overview

 IFRIC 2: Members shares in cooperative entities and similar instruments

 IFRIC 17: Distributions of non-cash assets to owners

2.1 IFRIC 2: Members shares in cooperative entities and similar instruments

Background
IFRIC 2 applies to financial instruments within the scope of IAS 32, including financial instruments
issued to members of co-operative entities that evidence the members’ ownership interest in the
entity.
Co-operatives (and similar entities) are formed by groups of persons to meet common economic
or social needs. Members’ interests in a co-operative are often described as “members’ shares”.
Members’ shares have characteristics of equity. For example, they give the member the rights to
vote and to participate in dividend distributions.
Members’ shares may also give the holder the right to request redemption for cash or another
financial asset but include limits on whether the financial instruments will be redeemed.
The issue
IAS 32 gives guidance on classification of financial instruments as financial liabilities or equity. The
guidance covers instruments that allow the holder to put those instruments to the issuer for cash
or another financial instrument (“puttable instruments”).
IFRIC 2 explains how redemption terms should be evaluated in determining whether the financial
instruments should be classified as liabilities or equity
Consensus
A contractual right of a holder to request redemption does not in itself mean that the financial
instrument must be classified as a financial liability.
An entity must consider all of the terms and conditions of the financial instrument to determine its
classification, including relevant local laws, regulations and the entity’s governing charter in effect
at the date of classification.
Members’ shares that give holders the right to request redemption are classified as equity when:
 the instrument would be classified as equity if there were no such terms attached; and
 the entity has an unconditional right to refuse redemption of the members’ shares; or
 redemption is unconditionally prohibited by local law, regulation or the entity’s governing
charter.

Example: Equity or liability

X co-operative has a charter which allows redemption of members’ shares at sole discretion of
the co-operative but redemption has never been refused.
Analysis
X co-operative has the unconditional right to refuse redemption so the members’ shares are
equity.
The fact that redemption has never been refused is not relevant in deciding the status of the
instruments.

Provisions that prohibit redemption only if conditions (such as liquidity constraints) are met/not met
do not result in members’ shares being equity.

© Emile Woolf International 210 The Institute of Chartered Accountants of Pakistan

 Chapter 10: Financial instruments: Presentation and disclosure

Example: Equity or liability

X co-operative has a charter which allows redemption of members’ shares at sole discretion of the
co-operative but also states that redemption is automatic unless X cannot make payments without
violating local regulations regarding liquidity.
Analysis
X co-operative does not have the unconditional right to refuse redemption so the members’ shares
are liabilities.

Unconditional prohibition may be:

 absolute
 all redemptions are prohibited
 members shares are equity
 partial
 redemption prohibited where it causes the number of members’ shares or amount of
paid-in capital from members’ shares to fall below a specified level

 Members’ shares above this level – liability

 Members’ shares below this level – equity

The limit may change from time to time – leading to a transfer between financial liabilities and
equity.

2.2 IFRIC 17: Distributions of non-cash assets to owners

Introduction
IFRIC 17 sets out guidance on how an entity should measure distributions of assets other than
cash when it pays dividends to owners in their capacity as owners.
Issues addressed:
 When should an entity recognise a dividend payable?
 How should an entity measure the dividend payable?
 When an entity settles the dividend payable, how should it account for any difference
between the carrying amount of the assets distributed and the carrying amount of the
dividend payable?
A dividend payable should be recognised when it is appropriately authorised and is no longer at
the discretion of the entity
Dividend payable should be measured at the fair value of the net assets to be distributed
Any difference between the dividend paid and the carrying amount of the net assets distributed is
recognised in profit and loss
Scope
Within scope:
 Distributions of non-cash assets (e.g. items of property, plant and equipment, businesses as
defined in IFRS 3, ownership interests in another entity or disposal groups under IFRS 5).
 Distributions that give owners choice of settlement in cash or non-cash assets.
The IFRIC applies only to distributions in which all owners of the same class of equity instruments
are treated equally.

© Emile Woolf International 211 The Institute of Chartered Accountants of Pakistan

Advanced accounting and financial reporting

Outside of the scope

 Distributions of non-cash assets that are ultimately controlled by the same party/parties
before and after the distribution, in separate, individual and consolidated financial
statements.
 Distributions of part ownership interests in a subsidiary with retention of control.
IFRIC 17 does not address the accounting for the non-cash distribution by the shareholders who
receive the distribution
Recognition of dividend payable
Dividend payable should be recognised when it is appropriately authorised and is no longer at the
discretion of the entity
This is:
 when the declaration is approved by the relevant authority where such approval is required
in the jurisdiction; or
 when the dividend is declared if no such approval is required
Measurement of a dividend payable
A liability to distribute non-cash assets to the owners as a dividend must be measured at the fair
value of the assets to be distributed
If the owners have a choice of receiving a non-cash asset or a cash alternative, the fair value of
each and the associated probability of owners selecting each alternative must be estimated.
Subsequent measurement:
The carrying amount of the dividend payable must be reviewed at the end of each reporting period
and at settlement with any changes in the amount of the dividend payable must be recognised in
equity.
Accounting for any difference
Any difference between the carrying amount of the assets distributed and the carrying amount of
the dividend payable at settlement must be recognised in profit and loss
Presentation and disclosure
Any difference between the carrying amounts of the dividend payable and the assets distributed
must be presented as a separate line item in the statement of profit or loss.
An entity must disclose:
 The brought forward and carried forward carrying amount of the dividend payable.
 Any decrease/increase in the carrying amount as a result of the change in the fair value of
the assets to be distributed
When a dividend of non-cash assets is declared after the end of the period but before the financial
statements are authorised for issue the entity must disclose the:
 nature of asset;
 carrying amount at period end;
 estimated fair value; and
 estimation methodology as required by IFRS 7

© Emile Woolf International 212 The Institute of Chartered Accountants of Pakistan

 Chapter 10: Financial instruments: Presentation and disclosure

3 IFRS 7: DISCLOSURE
Section overview

 Objectives of IFRS 7
 Statement of financial position disclosures
 Statement of profit or loss disclosures
 Risk disclosures

3.1 Objectives of IFRS 7

All companies are exposed to various types of financial risk. Some risks are obvious from looking
at the statement of financial position. For example, a loan requiring repayment in the next year is
reported as a current liability, and users of the financial statements can assess the risk that the
company will be unable to repay the loan.
However, there are often many other risks that a company faces that are not apparent from the
financial statements. For example, if a significant volume of a company’s sales are made overseas,
there is exposure to the risk of exchange rate movements.

Example:
A UK company has an investment of units purchased in a German company’s floating rate silver-
linked bond. The bond pays interest on the capital, and part of the interest payment represents
bonus interest linked to movements in the price of silver.
There are several financial risks that this company faces with respect to this investment.
It is a floating rate bond. So if market interest rates for bonds decrease, the interest income from
the bonds will fall.
Interest is paid in euros. For a UK company there is a foreign exchange risk associated with changes
in the value of the euro. If the euro falls in value against the British pound, the value of the income
to a UK investor will fall.
A bonus is linked to movements in the price of silver. So there is exposure to changes in the price
of silver.
There is default risk. The German company may default on payments of interest or on repayment
of the principal when the bond reaches its redemption date.
IFRS 7 requires that an entity should disclose information that enables users of the financial
statements to ‘evaluate the significance of financial instruments’ for the entity’s financial position
and financial performance.
There are two main parts to IFRS 7:
A section on the disclosure of ‘the significance of financial instruments’ for the entity’s financial
position and financial performance
A section on disclosures of the nature and extent of risks arising from financial instruments.

3.2 Statement of financial position disclosures

The carrying amounts of financial instruments must be shown, either in the statement of financial
position or in a note to the financial statements, for each class of financial instrument:
 Financial assets at fair value through profit or loss
 Financial assets at amortised cost
 Financial liabilities at fair value through profit or loss
 Financial liabilities measured at amortised cost.

© Emile Woolf International 213 The Institute of Chartered Accountants of Pakistan

Advanced accounting and financial reporting

Financial assets at fair value through profit or loss

If the entity has designated as measured at fair value through profit or loss a financial asset that
would otherwise be measured at fair value through other comprehensive income or amortised cost,
it shall disclose:
(a) the maximum exposure to credit risk of the financial asset at the end of the reporting period.
(b) the amount by which any related credit derivatives or similar instruments mitigate that
maximum exposure to credit risk.
(c) the amount of change, during the period and cumulatively, in the fair value of the financial
asset (or group of financial assets) that is attributable to changes in the credit risk of the
financial asset determined either:
i. as the amount of change in its fair value that is not attributable to changes in market
conditions that give rise to market risk; or
ii. using an alternative method the entity believes more faithfully represents the amount of
change in its fair value that is attributable to changes in the credit risk of the asset. Changes
in market conditions that give rise to market risk include changes in an observed
(benchmark) interest rate, commodity price, foreign exchange rate or index of prices or
rates.
(d) the amount of the change in the fair value of any related credit derivatives or similar instruments
that has occurred during the period and cumulatively since the financial asset was designated.

Financial liabilities at fair value through profit or loss

If the entity has designated a financial liability as at fair value through profit or loss and is required
to present the effects of changes in that liability’s credit risk in other comprehensive income, it shall
disclose:
(a) the amount of change, cumulatively, in the fair value of the financial liability that is attributable
to changes in the credit risk of that liability
(b) 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.
(c) any transfers of the cumulative gain or loss within equity during the period including the reason
for such transfers.
(d) if a liability is derecognised during the period, the amount (if any) presented in other
comprehensive income that was realised at derecognition.
The entity shall also disclose:
(a) a detailed description of the methods used including an explanation of why the method is
appropriate.
(b) if the entity believes that the disclosure it has given, either in the statement of financial position
or in the notes, does not faithfully represent the change in the fair value of the financial asset
or financial liability attributable to changes in its credit risk, the reasons for reaching this
conclusion and the factors it believes are relevant.
(c) a detailed description of the methodology or methodologies used to determine whether
presenting the effects of changes in a liability’s credit risk in other comprehensive income
would create or enlarge an accounting mismatch in profit or loss
Investments in equity instruments designated at fair value through other comprehensive income
If an entity has designated investments in equity instruments to be measured at fair value through
other comprehensive income, it shall disclose:
(a) which investments in equity instruments have been designated to be measured at fair value
through other comprehensive income.

© Emile Woolf International 214 The Institute of Chartered Accountants of Pakistan

 Chapter 10: Financial instruments: Presentation and disclosure

(b) the reasons for using this presentation alternative.

(c) the fair value of each such investment at the end of the reporting period.
(d) dividends recognised during the period,
(e) any transfers of the cumulative gain or loss within equity during the period including the reason
for such transfers.
Other disclosures relating to the statement of financial position are also required. These include
the following:
 Collateral. A note should disclose the carrying amount of financial assets that the entity has
pledged as collateral for liabilities or contingent liabilities, the terms and conditions relating
to its pledge.
 Allowance account for credit losses. The carrying amount of financial assets measured
at fair value through other comprehensive income (in accordance with paragraph 4.1.2A of
IFRS 9) is not reduced by a loss allowance and an entity should not present the loss
allowance separately in the statement of financial position as a reduction of the carrying
amount of the financial asset. However, an entity must disclose the loss allowance in the
notes to the financial statements.
 Defaults and breaches. For loans payable, the entity should disclose details of any defaults
during the period in the loan payments, or any other breaches in the loan conditions.
With some exceptions, for each class of financial asset and financial liability, an entity must disclose
the fair value of the assets or liabilities in a way that permits the fair value to be compared with the
carrying amount for that class. An important exception is where the carrying amount is a reasonable
approximation of fair value, which should normally be the case for short-term receivables and
payables.

3.3 Statement of profit or loss disclosures

An entity must disclose the following items either in the statement of profit or loss or in notes to the
financial statements:
 Net gains or losses on financial assets or financial liabilities at fair value through profit or
loss.
 Net gains or losses on available-for-sale financial assets, showing separately:
 the gain or loss recognised in other comprehensive income (and so directly in equity)
during the period, and
 the amount removed from equity and reclassified from equity to profit and loss through
other comprehensive income in the period.
 Total interest income and total interest expense, calculated using the effective interest
method, for financial assets or liabilities that are not at fair value through profit or loss.
 Fee income and expenses arising from financial assets or liabilities that are not at fair value
through profit or loss.
Other disclosures
IFRS 7 also requires other disclosures. These include the following:
 With some exceptions, for each class of financial asset and financial liability, an entity must
disclose the fair value of the assets or liabilities in a way that permits the fair value to be
compared with the carrying amount for that class. An important exception is where the
carrying amount is a reasonable approximation of fair value, which should normally be the
case for short-term receivables and payables.

3.4 Risk disclosures

IFRS 7 also requires that an entity should disclose information that enables users of its financial
statements to evaluate the nature and extent of the risks arising from its financial instruments.

© Emile Woolf International 215 The Institute of Chartered Accountants of Pakistan

Advanced accounting and financial reporting

These risks typically include, but are not restricted to:

 Credit risk
 Liquidity risk and
 Market risk
For each category of risk, the entity should provide both quantitative and qualitative information
about the risks.
 Qualitative disclosures. For each type of risk, there should be disclosures of the exposures
to risk and how they arise; and the objectives policies and processes for managing the risk
and the methods used to measure the risk.
 Quantitative disclosures. For each type of risk, the entity should also disclose summary
quantitative data about its exposures at the end of the reporting period. This disclosure
should be based on information presented to the entity’s senior management, such as the
board of directors or chief executive officer.
Credit risk
Credit risk is the risk that someone who owes money (a trade receivable, a borrower, a bond issuer,
and so on) will not pay. An entity is required to disclose the following information about credit risk
exposures:
 A best estimate of the entity’s maximum exposure to credit risk at the end of the reporting
period and a description of any collateral held.
Liquidity risk
Liquidity risk is the risk that the entity will not have access to sufficient cash to meet its payment
obligations when these are due. IFRS 7 requires disclosure of:
 A maturity analysis for financial liabilities, showing when the contractual liabilities fall due for
payment
 A description of how the entity manages the liquidity risk that arises from this maturity profile
of payments.
Market risk
Market risk is the risk of losses that might occur from changes in the value of financial instruments
due to changes in:
 Exchange rates,
 Interest rates, or
 Market prices.
An entity should provide a sensitivity analysis for each type of market risk to which it is exposed at
the end of the reporting period. The sensitivity analysis should show how profit or loss would have
been affected by a change in the market risk variable (interest rate, exchange rate, market price of
an item) that might have been reasonably possible at that date.
Alternatively, an entity can provide sensitivity analysis in a different form, where it uses a different
model for analysis of sensitivity, such as a value at risk (VaR) model. These models are commonly
used by banks.

© Emile Woolf International 216 The Institute of Chartered Accountants of Pakistan

 Chapter 10: Financial instruments: Presentation and disclosure

SOLUTIONS TO PRACTICE QUESTIONS

Solution 1
a) Split of liability and equity on initial recognition
Discount Present value
Cash (Rs.)
31st December factor 9% (Rs.)
20X5 - interest 100,000 0.9174 91,743
20X6 - interest 100,000 0.8417 84,168
20X7 - interest 100,000 0.7722 77,218
20X7 - principal 2,000,000 0.7722 1,544,367

Fair value of bond 1,797,496

Value of equity (balance) 202,504

Proceeds from issue of bond 2,000,000

b) Journal on initial recognition Dr (Rs.) Cr (Rs.)

Cash 2,000,000
Liability 1,797,496
Equity 202,504

c) Amortisation table
Liability at start Finance charge at Liability at
Interest paid
of year 9% end of year
Rs. Rs. Rs. Rs.
20X5 1,797,496 161,775 (100,000) 1,859,271
20X6 1,859,271 167,334 (100,000) 1,926,605
20X7 1,926,605 173,395 (100,000) 2,000,000

d) Journal on conversion to shares Rs. Rs.

Bond 2,000,000
Equity - option proceeds 202,504
Share capital 1,200,000
Share premium 1,002,504

© Emile Woolf International 217 The Institute of Chartered Accountants of Pakistan

Advanced accounting and financial reporting

© Emile Woolf International 218 The Institute of Chartered Accountants of Pakistan

 Certified Finance and Accounting Professional

11

CHAPTER
Advanced accounting and financial reporting

IAS 19: Employee benefits

Contents
1 Employee benefits
2 Post-employment benefits
3 IFRIC 14: IAS 19 – The limit on a defined benefit asset,
minimum funding requirements and their interaction

© Emile Woolf International 219 The Institute of Chartered Accountants of Pakistan

Advanced accounting and financial reporting

1 EMPLOYEE BENEFITS
Section overview

 The scope and basic principles

 Short-term employee benefits
 Termination benefits
 Other long term benefits

1.1 The scope and basic principles

Definition
Employee benefits are all forms of consideration given by an entity in exchange for service
rendered by employees or for the termination of employment.

A company may reward its employees in ways other than payment of a basic salary. Employers
often provide entitlements to paid holidays, or pay an annual cash bonus to some employees, or
provide employees with a company car, medical insurance and pension benefits. (Some
employees also receive shares or share options subject to the condition that the employee remains
with the entity for a specified time period: these are classified as share-based payments and should
be dealt in accordance with IFRS 2.)
IAS 19 provides guidance on accounting for all forms of employee benefits, except for share-based
payments.
IAS 19 sets out rules of accounting and disclosure for:
 short term employee benefits (discussed in 1.2 below);
 post-employment benefits, such as the following:
 retirement benefits (e.g. pensions and lump sum payments on retirement); and
 other post-employment benefits, such as post-employment life insurance and post-
employment medical care;
 other long-term employee benefits, such as the following:
 long-term paid absences such as long-service leave or sabbatical leave;
 jubilee or other long-service benefits; and
 long-term disability benefits; and
 termination benefits.
Accounting principle
The basic principle in IAS 19 is that the cost of providing benefits to employees should be matched
with the period during which the employees work to earn the benefits. This principle applies even
when the benefits are payable in the future, such as pension benefits.
IAS 19 requires an entity:
 to recognise a liability when an employee has provided a service in exchange for a benefit
that will be paid in the future, and
 to recognise an expense when the entity makes use of the service provided by the employee.
The basic double entry may therefore be (depending on the nature of the employee benefits):
Debit: Employment cost (charged as an expense in the statement of profit or loss)
Credit: Liability for employee benefits

© Emile Woolf International 220 The Institute of Chartered Accountants of Pakistan

 Chapter 11: IAS 19: Employee benefits

1.2 Short-term employee benefits

Definition
Short-term employee benefits are employee benefits that expected to be settled wholly within
twelve months after the end of the annual reporting period in which the employee renders the
service.

Short-term employee benefits include:

 wages, salaries and social security contributions
 paid annual holiday and paid absences due to sickness
 profit-sharing payments and bonuses
 other benefits not in a monetary form, such as medical insurance, free accommodation in a
house or flat owned by the entity, company maintained cars and free or subsidised goods.
The expense must be accounted for on an accruals basis and any unpaid entitlement should be
recognised as a short-term liability. Discounting the liability to a present value is not required,
because it is payable within 12 months.
Short-term paid absences
Sometimes an entity may pay employees for absence for various reasons. These include holidays,
sickness and maternity leave.
Entitlement to paid absences falls into two categories:
 accumulating
 carried forward for use in future periods if the current period’s entitlement is not used
in full;
 expense and liability is recognised when employees render service that increases
their entitlement to future paid absences
 measured at the additional amount expected to be paid as a result of the unused
entitlement that has accumulated at the end of the reporting period.
 non-accumulating.
 unused amounts cannot be carried forward;
 expense and liability is recognised when the absences occur.
Profit-sharing and bonus plans
The expected cost of profit-sharing and bonus payments must be recognised when, and only when:
 the entity has a present legal or constructive obligation to make such payments as a result
of past events; and
 a reliable estimate of the obligation can be made.
A reliable estimate of its legal or constructive obligation under a profit-sharing or bonus plan can
be made when, and only when:
 the formal terms of the plan contain a formula for determining the amount of the benefit;
 the entity determines the amounts to be paid before the financial statements are authorised
for issue; or
 past practice gives clear evidence of the amount of the entity’s constructive obligation.
A present obligation exists when, and only when, the entity has no realistic alternative but to make
the payments.

© Emile Woolf International 221 The Institute of Chartered Accountants of Pakistan

Advanced accounting and financial reporting

1.3 Termination benefits

Definition
Termination benefits are employee benefits provided in exchange for the termination of an
employee’s employment as a result of either:
a. an entity’s decision to terminate an employee’s employment before the normal retirement
date; or
b. an employee’s decision to accept an offer of benefits in exchange for the termination of
employment.

However, termination benefits do not include employee benefits resulting from;

 termination of employment at the request of the employee without an entity’s offer e.g..
resignation, or
 as a result of mandatory retirement requirements (e.g an employee reaches 60 years of
age), because those benefits are post-employment benefits.
Some entities provide a lower level of benefit for termination of employment at the request of the
employee (in substance, a post-employment benefit) than for termination of
employment at the request of the entity.
Recognition
An entity must recognise a liability and expense for termination benefits at the earlier of the
following dates:
 when the entity can no longer withdraw the offer of those benefits; and
 when the entity recognises costs for a restructuring within the scope of IAS 37 that involves
the payment of termination benefits.
Measurement
Termination benefits are measured in accordance with the nature of the employee benefit, that is
to say short term benefits, other long term benefits or post-employment benefits.

1.4 Other long term benefits

Definition
Other long-term employee benefits are all employee benefits other than short-term employee
benefits, post-employment benefits and termination benefits e.g. long-term disability benefits.

An entity must recognise a net liability (asset) for any other long term benefit. This is measured as:
 the present value of the obligation for the benefit; less
 the fair value of assets set aside to meet the obligation (if any).
Movements in the amount from one year to the next are recognised in P&L.

© Emile Woolf International 222 The Institute of Chartered Accountants of Pakistan

 Chapter 11: IAS 19: Employee benefits

2 POST-EMPLOYMENT BENEFITS
Section overview

 Post-employment benefits
 Defined contribution pension plans
 Defined benefit pension plans
 Introduction to accounting for defined benefit pension plans
 Accounting for defined benefit pension plans
 Accounting for defined benefit pension plans – Alternative approach
 Asset ceiling example
 Multi-employer plans
 Presentation
 Disclosure

2.1 Post-employment benefits

Definition
Post-employment benefits are employee benefits (other than termination benefits and short-term
employee benefits) that are payable after the completion of employment.

The most significant post-employment benefit is a retirement pension, but there may also be post-
employment life insurance and medical care.

Definition
Post-employment benefit plans are formal or informal arrangements under which an entity
provides post-employment benefits for one or more employees.

There are two types of post-employment benefit plan:

 defined contribution plans; and
 defined benefit plans.
Definitions
Defined contribution plans are post-employment benefit plans under which an entity pays fixed
contributions into a separate entity (a fund) and will have no legal or constructive obligation to pay
further contributions if the fund does not hold sufficient assets to pay all employee benefits relating
to employee service in the current and prior periods.
Defined benefit plans are post-employment benefit plans other than defined contribution plans.

2.2 Defined contribution pension plans

In a defined contribution pension plan, the employer pays an agreed amount of money (‘defined
contributions’) at regular intervals into a pension fund for the employee. The amount of money that
the employer contributes is usually a fixed percentage of the employee’s wages or salary (e.g. 5%
of the employee’s basic salary).
The contributions to the fund are invested to earn a return and increase the value of the fund. When
an employee retires, he or she is paid a pension out of the fund. The amount of pension received
by the employee is not pre-determined, but depends on the size of the employee’s share of the
fund at retirement.
As the name ‘defined contribution’ implies, the company’s obligation to pay a pension to the
employee is limited to the agreed amounts of contribution. The company is not required to make
good any shortfalls if the pension fund does not have enough assets to pay the pension benefits
that the employee would like to have. In effect, the employee bears the risk of a poor-performing
fund, not the employer.

© Emile Woolf International 223 The Institute of Chartered Accountants of Pakistan

Advanced accounting and financial reporting

Accounting treatment: contributions to defined contribution schemes

Accounting for the employer’s contributions to a defined contribution scheme is straightforward.
Using the accruals concept:
 the contributions payable for the reporting period are charged to profit or loss as an expense
(an employee cost) in the statement of profit or loss.
 any unpaid contributions at the end of the year will be shown in the statement of financial
position as an accrual/liability and any prepaid contributions will be shown as an asset (a
prepayment).

2.3 Defined benefit pension plans

Under a defined benefit plan, the employer guarantees the amount of pension that its employees
will receive after they retire. A company might save cash into a separate fund (just as for defined
contribution plans) in order to build up an asset that can be used to pay the pensions of employees
when they retire. This would be known as a funded plan. If an employer does not save up in this
way the plan is described as being unfunded.
The amount that an employee will receive is usually linked to the number of years that he or she
has worked for the company, and the size of his/her annual salary at retirement date (or on leaving
the company). Defined benefit plans are often known as “final salary schemes”
If there are insufficient funds in the plan to provide employees with the guaranteed pensions then
the employer must make up the shortfall. The risk remains with the employer.
Role of an actuary
An actuary is a highly qualified specialist in the financial impact of risk and uncertainty. They advise
companies on the conduct of their pension plans.
An actuary will advise the company how much to pay in contributions into the pension plan each
year, in order to ensure there are sufficient funds to cover the company’s obligation to make the
pension payments. This involves making a large number of estimates. For example, the actuary
has to estimate the average life expectancy of retired employees, the expected number of years
of service that retired employees will have given when they retire, their final salary and the expected
returns on investments in the pension fund.
It is very unlikely that the actuary’s estimates will be 100% accurate so whenever the value of the
pension fund assets and the employer’s pension obligations are measured, the company may find
that there is a deficit or a surplus.
 When the amount of the employer’s future pension obligations is more than the value of the
investments in the pension fund, the fund is in deficit.
 When the value of the investments in the pension fund is higher than the value of the
employer’s obligations to make future pension payments, the fund is in surplus.
When a surplus or deficit occurs an employer might take no action. This would be the case when
the company believes that the actuarial assumptions may not be true in the short term but will be
true over the long term. Alternatively, the company might decide to eliminate a deficit (not
necessarily immediately) by making additional contributions into the fund.
When the fund is in surplus, the employer might stop making contributions into the fund for a period
of time (and ‘take a pension holiday’). Alternatively, in some jurisdictions the company may
withdraw the surplus from the fund for its own benefit though this is not allowed in Pakistan.
2.4 Introduction to accounting for defined benefit pension plans
Pensions are paid by the defined benefit plan which is a separate legal entity from the company.
However, the company has the legal obligation to pay the pensions.
The defined benefit plan is a special entity set up in order to handle a large number of complex
and long term transactions for the company and to separate the plan’s assets from those of the
company (the pensions of the employees are protected if the company runs into difficulties).

© Emile Woolf International 224 The Institute of Chartered Accountants of Pakistan

 Chapter 11: IAS 19: Employee benefits

Statement of financial position

IAS 19 requires that an entity must recognise a defined benefit item (net liability due to a deficit or
net asset due to a surplus) in the statement of financial position.
The net defined benefit liability (asset) is the deficit or surplus and is measured as:
 the present value of the defined benefit obligation; less
 the fair value of plan assets (if any).
A surplus in a defined benefit plan is measured at the lower of:
 the surplus in the defined benefit plan; and
 the asset ceiling (which is the present value of any economic benefits available in the form
of refunds from the plan or reductions in future contributions to the plan).

Definition
The present value of a defined benefit obligation is the present value, without deducting any plan
assets, of expected future payments required to settle the obligation resulting from employee
service in the current and prior periods.

The obligation is estimated by an actuary, and is based on actuarial estimates and assumptions.
IAS 19 requires that it must be measured using the projected unit credit method (you may need to
know this term but do not need to apply it) using a discount rate available on high quality corporate
bonds.
Movement for the period
The movements on the defined benefit item are due to:
 cash contributions to the plan
 current service cost (to P&L);
 past service cost (to P&L);
 gains or loss on settlement (to P&L);
 net interest (expense or income) (to P&L); and
 remeasurement (to OCI);
Note that the benefit paid has no effect as it reduces the plan assets and plan obligations by the
same amount.
Definitions – Movements recognised through P&L

Definitions
Current service cost is the increase in the present value of the defined benefit obligation resulting
from employee service in the current period;
Past service cost is the change in the present value of the defined benefit obligation for employee
service in prior periods, resulting from a plan amendment (the introduction or withdrawal of, or
changes to, a defined benefit plan) or a curtailment (a significant reduction by the entity in the
number of employees covered by a plan).
Net interest on the net defined benefit liability (asset) is the change during the period in the net
defined benefit liability (asset) that arises from the passage of time.
A settlement is a transaction that eliminates all further legal or constructive obligations for part or
all of the benefits provided under a defined benefit plan, other than a payment of benefits to, or on
behalf of, employees that is set out in the terms of the plan and included in the actuarial
assumptions.

© Emile Woolf International 225 The Institute of Chartered Accountants of Pakistan

Advanced accounting and financial reporting

Definitions – Movements recognised through OCI

Definitions
Remeasurements of the net defined benefit liability (asset) comprise:
a. actuarial gains and losses;
b. the returns on plan assets, excluding amounts included in net interest on the net defined
liability (asset); and
c. any change in the effect of the asset ceiling, excluding amounts included in net interest on
the net defined benefit liability (asset).
Actuarial gains and losses are changes in the present value of the defined benefit obligation
resulting from:
a. experience adjustments (the effects of differences between the previous actuarial
assumptions and what has actually occurred); and
b. the effects of changes in actuarial assumptions.

2.5 Accounting for defined benefit pension plans

Step 1
Construct a note to show the net liability (net asset) that is recognised on the face of the statement
of financial position. This note should include both amounts for the current year and comparatives.

Illustration: Defined benefit net liability (asset)

Opening Closing
Present value of plan obligation X X
Fair value of plan assets X X
X X

This is used to identify the movement on the defined benefit liability (asset) which is journalised at
step 2
Step 2
Construct the following journal and enter the movement on the defined benefit liability (asset) and
the cash paid to the plan by the company (contributions).

Illustration: Journal
Debit Credit
Profit or loss X
Other comprehensive income
(remeasurement) X
Cash (contributions) X
Defined benefit net liability X

The above illustration assumes an increase in the liability. This would not be the case in all
examples. (In other words, the movement might be a debit or a credit, depending on circumstance).
Step 3
Identify the profit and loss entries. These comprise:
 current service cost;
 past service cost (if any);
 interest (an interest rate applied to the opening net liability (asset); and
 settlement gain/loss

© Emile Woolf International 226 The Institute of Chartered Accountants of Pakistan

 Chapter 11: IAS 19: Employee benefits

Enter the total into the journal.

Step 4
Calculate the remeasurement as a balancing figure.

Example: Defined benefit accounting

The following information relates to the defined benefit plan of Company X for the year to 31
December 20X6.
At 1 January 20X6: Rs. 000
Fair value of the plan assets 900
Present value of the plan obligations 1,850

During 20X6: Rs. 000

Current service cost 90
Contributions paid into the plan 150
Benefits paid out by the plan 60

Actuarial assumptions:
Discount rate 10%

New actuarial valuation at 31 December 20X6: Rs. 000

Fair value of the plan assets 850
Present value of the plan obligations 1,960

Construct a journal to show the movement on the defined benefit account.

Answer: Defined benefit accounting

Step 1: The opening position
1 January 31 December
20X6 20X6
Rs. 000 Rs. 000
Present value of plan obligation 1,850 1,960
Fair value of plan assets (900) (850)
950 1,110

Note that the movement on the defined benefit liability is an increase of Rs. 160,000 (1,110,000
– 950,000)

Step 2: Construct the journal and fill in the blanks as far as possible

Debit Credit

Rs. 000 Rs. 000

Profit or loss

Other comprehensive income

(remeasurement)

Cash (contributions) 150

Defined benefit net liability 160

© Emile Woolf International 227 The Institute of Chartered Accountants of Pakistan

Advanced accounting and financial reporting

Answer: Defined benefit accounting (continued)

Step 3: Identify amounts to be recognised in profit or loss
Rs. 000
Current service cost 90
Interest (10%  Rs. 950,000) 95
185

Step 4: Complete the journal by calculating the remeasurement as a balancing figure

Debit Credit
Rs. 000 Rs. 000
Profit or loss 185
Other comprehensive income
(remeasurement as a balancing figure) 125
Cash (contributions) 150
Defined benefit net liability 160
310 310

2.6 Accounting for defined benefit pension plans – Alternative approach

Steps 1 and 2 are as before. The difference is in the calculation of the remeasurement.
This involves rolling the opening figures forward to the year end. The approach is to calculate what
the closing defined benefit net liability (net asset) should be by adjusting the opening defined
benefit net liability (asset) by what has happened in the period and by applying the actuarial
assumptions.
This balance can then be compared with the actual closing balance and the remeasurement
identified as a balancing figure.
This accounting treatment can best be explained using an example:

Example: Defined benefit accounting

The following information relates to the defined benefit plan of Company X for the year to 31
December 20X6.
At 1 January 20X6: Rs. 000
Fair value of the plan assets 900
Present value of the plan obligations 1,850

During 20X6: Rs. 000

Current service cost 90
Contributions paid into the plan 150
Benefits paid out by the plan 60

Actuarial assumptions:
Discount rate 10%

New actuarial valuation at 31 December 20X6: Rs. 000

Fair value of the plan assets 850
Present value of the plan obligations 1,960

Construct a journal to show the movement on the defined benefit account.

© Emile Woolf International 228 The Institute of Chartered Accountants of Pakistan

 Chapter 11: IAS 19: Employee benefits

Answer: Defined benefit accounting

Step 1: The opening position (as before)

1 January 31 December
20X6 20X6
Rs. 000 Rs. 000
Present value of plan obligation 1,850 1,960
Fair value of plan assets (900) (850)
950 1,110

Step 2: Construct the journal and fill in the blanks as far as possible (as before)
Debit Credit
Rs. 000 Rs. 000
Profit or loss
Other comprehensive income
(remeasurement)
Cash (contributions) 150
Defined benefit net liability 160

Step 3: Construct a working to identify the movements on the defined benefit net liability (asset)
Rs. 000
At start of year (950)
1 Net interest (10% × 950,000) (95)
2 Contributions paid (given) 150
3 Current service cost (given) (90)
4 Benefits paid out (given) 0
Expected year end position (985)
Remeasurement (balancing figure) (125)
Actual year end position (1,110)
Step 4: Complete the journal by entering in the profit and loss amounts and the remeasurement
from the above working.
Debit Credit
Rs. 000 Rs. 000
Profit or loss (Rs. 95,000 + Rs. 90,000) 185
Other comprehensive income 125
Cash (contributions) 150
Defined benefit net liability 160
310 310

© Emile Woolf International 229 The Institute of Chartered Accountants of Pakistan

Advanced accounting and financial reporting

Possible complication
In the above illustration the opening defined benefit net liability (asset) was rolled forward.
IAS 19 requires disclosure of reconciliations of the present value of the defined benefit obligation
and the fair value of the defined benefit assets.
This is done by constructing a similar working to that shown in step 3 above but including further
columns for both the defined benefit liability and the defined benefit asset.

Example:
Using the facts from the previous example the working would be as follows:

Step 3: Construct a working to identify the movements on the defined benefit net liability (asset)
Company
Fund position position
Liability Assets Net
Rs. 000 Rs. 000 Rs. 000
At start of year (1,850) 900 (950)
1 Interest expense (10% × 1,850,000) (185) (185)
1 Interest earned (10% × 900,000) 90 90
1 Net interest (10% × 950,000) (95)
2 Contributions paid (given) 150 150
3 Current service cost (given) (90) (90)
4 Benefits paid out (given) 60 (60) 0
Expected year end position (2,065) 1,080 (985)
Remeasurement (balancing figure) 105 (230) (125)
Actual year end position (1,960) 850 (1,110)

Note, that this explains why the benefits paid do not figure in the double entry. When benefit is paid
it reduces both the asset and the liability and in consequence has no impact on the net position.

2.7 Asset ceiling example

IAS 19 requires that an entity must recognise a defined benefit item (net liability due to a deficit or
net asset due to a surplus) in the statement of financial position.
The net defined benefit liability (asset) is the deficit or surplus and is measured as:
 the present value of the defined benefit obligation; less
 the fair value of plan assets (if any).
However, if the net item is a surplus it is subject to a test which puts a ceiling on the amount that
can be recognised. This is known as the “asset ceiling” test.
A surplus in a defined benefit plan is measured at the lower of:
 the surplus in the defined benefit plan; and
 the asset ceiling (which is the present value of any economic benefits available in the form
of refunds from the plan or reductions in future contributions to the plan).
The approach is exactly the same as before except that net defined benefit assets recognised at
step 1 must be adjusted downwards to the asset ceiling.

© Emile Woolf International 230 The Institute of Chartered Accountants of Pakistan

 Chapter 11: IAS 19: Employee benefits

Example: Defined benefit accounting with asset ceiling

The following information relates to the defined benefit plan of Company X for the year to 31
December 20X6.
At 1 January 20X6: Rs. 000
Fair value of the plan assets 1,150
Present value of the plan obligations 1,100
Present value of economic benefits available due to rules in
the jurisdiction 40

During 20X6: Rs. 000

Current service cost 125
Contributions paid into the plan 80
Benefits paid out by the plan 130

Actuarial assumptions:
Discount rate 10%

New actuarial valuation at 31 December 20X6: Rs. 000

Fair value of the plan assets 1,395
Present value of the plan obligations 1,315
Present value of economic benefits available due to rules in
the jurisdiction 65

Construct a journal to show the movement on the defined benefit account.

Answer: Defined benefit accounting with asset ceiling

Step 1: The opening position
1 January 31 December
20X6 20X6
Rs. 000 Rs. 000
Fair value of plan assets 1,150 1,395
Present value of plan obligation (1,100) (1,315)
50 80
Asset ceiling adjustment (balancing figure) (10) (15)

Asset ceiling (PV of economic benefits

available 40 65

Note that the movement on the defined benefit asset is an increase of Rs. 25,000 (65,000 –
40,000)
Step 2: Construct the journal and fill in the blanks as far as possible (as before)
Debit Credit
Rs. 000 Rs. 000
Profit or loss
Other comprehensive income
(remeasurement)
Cash (contributions) 80
Defined benefit net asset 25

© Emile Woolf International 231 The Institute of Chartered Accountants of Pakistan

Advanced accounting and financial reporting

Answer: Defined benefit accounting with asset ceiling (continued)

Step 3: Identify amounts to be recognised in profit or loss

Rs. 000

Current service cost (125)

Interest credit (10%  40,000) 4

121

Step 4: Complete the journal by calculating the remeasurement as a balancing figure

Debit Credit

Rs. 000 Rs. 000

Profit or loss 121

Other comprehensive income

(remeasurement as a balancing figure) 66

Cash (contributions) 80

Defined benefit net asset 25

146 146

2.8 Multi-employer plans

Multi-employer plans are defined contribution plans (other than state plans) or defined benefit plans
that:
 pool the assets contributed by various entities that are not under common control; and
 use those assets to provide benefits to employees of more than one entity, on the basis that
contribution and benefit levels are determined without regard to the identity of the entity that
employs the employees.
Any multi-employer plan must be classified as a defined contribution plan or a defined benefit plan.
If an entity participates in a multi-employer defined benefit plan it must account for its proportionate
share of the defined benefit obligation, plan assets and cost associated with the plan in the same
way as for any other defined benefit plan.
If sufficient information is not available to use defined benefit accounting for a multi-employer
defined benefit plan, an entity must account for it as if it were a defined contribution plan.
Group plans
Defined benefit plans that share risks between entities under common control (e.g. a parent and
its subsidiaries) are not multi-employer plans.
Any entity participating in a defined benefit plan that shares risks between entities under common
control must disclose:
 the contractual agreement or stated policy for charging the net defined benefit cost or the
fact that there is no such policy.
 the policy for determining the contribution to be paid by the entity.

© Emile Woolf International 232 The Institute of Chartered Accountants of Pakistan

 Chapter 11: IAS 19: Employee benefits

2.9 Presentation
Offset
An entity shall offset an asset relating to one plan against a liability relating to another plan when,
and only when, the entity:
(a) has a legally enforceable right to use a surplus in one plan to settle obligations under the other
plan; and
(b) intends either to settle the obligations on a net basis, or to realise the surplus in one plan and
settle its obligation under the other plan simultaneously.
2.10 Disclosure
An entity shall disclose information that:
(a) explains the characteristics of its defined benefit plans and risks associated with them;
(b) identifies and explains the amounts in its financial statements arising from its defined benefit
plans; and
(c) describes how its defined benefit plans may affect the amount, timing and uncertainty of the
entity’s future cash flows

© Emile Woolf International 233 The Institute of Chartered Accountants of Pakistan

Advanced accounting and financial reporting

3 IFRIC 14: IAS19 – THE LIMIT ON A DEFINED BENEFIT ASSET, MINIMUM

FUNDING REQUIREMENTS AND THEIR INTERACTION

Section overview

 IFRIC 14: IAS 19 – The limit on a defined benefit asset, minimum funding requirements and their
interaction
 Consensus – Availability of benefits
 Consensus – Impact of minimum funding requirement and future benefits available in the form of
refunds
 Consensus – Impact of minimum funding requirement and future benefits available in the form of
a reduction in future contributions

3.1 IFRIC 14: IAS 19 – The limit on a defined benefit asset, minimum funding
requirements and their interaction
Background
As explained above, IAS 19 limits the measurement of a net defined benefit asset to the lower of
the surplus in the defined benefit plan and the asset ceiling (the present value of any economic
benefits available in the form of refunds from the plan or reductions in future contributions to the
plan).
However, IAS 19 does not give guidance on when refunds or reductions in future contributions
should be regarded as available, particularly when a minimum funding requirement exists.
Minimum funding requirement
Minimum funding requirements exist in many countries to improve the security of the
post-employment benefit promise made to members of an employee benefit plan. Such
requirements normally stipulate a minimum amount of contributions that must be made to a plan
over a given period. Therefore, a minimum funding requirement may limit the ability of the entity to
reduce future contributions.
This is a requirement for a company to make contributions to fund a defined benefit plan.
 The existence of a minimum funding requirement might result in a legal requirement to make
a payment to a plan that is an asset according to IAS 19.
 A minimum funding requirement might result in a payment to a plan that would turn a plan
deficit into a plan surplus as discussed in IAS 19.
The interaction of a minimum funding requirement and the limit in the IAS 19 asset ceiling test has
two possible effects:
 it might restrict the economic benefits available as a reduction in future contributions;
 may give rise to a liability if the contributions required under the minimum funding
requirement will not be available to the entity once they have been paid (either as a refund
or as a reduction in future contributions). The minimum funding requirement becomes
onerous
Issues
The issues addressed by IFRIC 14:
 when refunds or reductions in future contributions should be regarded as available in
accordance with the definition of the asset ceiling in IAS 19;
 how a minimum funding requirement might affect the availability of reductions in future
contributions; and
 when a minimum funding requirement might give rise to a liability

© Emile Woolf International 234 The Institute of Chartered Accountants of Pakistan

 Chapter 11: IAS 19: Employee benefits

3.2 Consensus – Availability of benefits

An economic benefit (as a refund or reduction in future contributions) is available if the entity can
realise it at some point during the life of the plan or when the plan liabilities are settled.
It does not have to be realisable immediately at the reporting date.
Economic benefit available as a refund
Economic benefit is only available as a refund if a company has an unconditional right to that
refund.
An unconditional right to a refund:
 can exist whatever the funding level of a plan at the reporting date; but
 cannot exist subject to occurrence or non-occurrence of one or more uncertain future events
not wholly within its control.
Any such right should be measured as the amount of the surplus at the reporting date that the
entity has a right to receive as a refund, less any associated costs.
Economic benefit available as a reduction in future contributions
Economic benefit available as a reduction in future contribution is measured with reference to the
amount that the entity would have been required to pay had there been no surplus. This is
represented by the future IAS 19 service cost.
There are three situations to consider:
 availability if there is no minimum funding requirement;
 whether the minimum funding requirement may give rise to a liability; and
 availability if there is a minimum funding requirement.
No minimum funding requirement
Where there is no minimum funding requirement the economic benefit available is the lower of:
 the surplus in the plan; and
 the present value of the future service cost to the entity (excluding any part borne by
employees) for each year over the shorter of the expected life of the plan and the expected
life of the entity
Minimum funding requirement
If an entity has an obligation to pay contributions to cover an existing shortfall (on the minimum
funding basis) in respect of services already received, it must determine whether these
contributions will be available as a refund or reduction in future contributions after they are paid
into the plan.

3.3 Consensus – Impact of minimum funding requirement and future benefits available
in the form of refunds
A minimum funding requirement might result in cash being owed to a plan.
Whether a liability should be recognised depends on the recoverability of the amounts that are to
be paid.
A liability is recognised for any amount not available after they are paid into the plan. Any such
liability would reduce the net defined benefit asset or increase the net defined benefit liability.

© Emile Woolf International 235 The Institute of Chartered Accountants of Pakistan

Advanced accounting and financial reporting

Example: Recognition of liability for a minimum funding requirement

X Limited has a post-employment plan subject to a minimum funding requirement (MFR) as a result
of which it has a statutory obligation to contribute Rs. 200m to the plan as at the reporting date.
The plan rules permit a full refund of any surplus to the entity at the end of the life of the plan.
Year-end valuation of the plan is set out below:
2016
Rs. m
Market value of plan assets 1,200
Present value of plan obligations (1,100)
Defined benefit asset (before accounting for the
MFR in accordance with IFRIC 14). 100
Liability recognised for MFR nil
Defined benefit net asset 100
The amounts in the plan will be available for refund in the future so there is no need to
recognise a liability in respect of the minimum funding requirement.
Market value of plan assets 1,200
Present value of plan obligations (1,100)
100
Adjustment for asset ceiling (100)
Defined benefit balance (before accounting for the
MFR in accordance with IFRIC 14). nil
Liability recognised for MFR (200)
Defined benefit net liability (200)

The amounts in the plan are not available for refund in the future so there a liability in respect
of the minimum funding requirement is required.

Example: Recognition of liability for a minimum funding requirement

X Limited has a post-employment plan subject to a minimum funding requirement (MFR) as a result
of which it has a statutory obligation to contribute Rs. 200m to the plan as at the reporting date.
The plan rules allow for the refund of 60% of any surplus that arise according to IAS 19.
Year-end valuation of the plan is set out below:
2016
Rs. m
Market value of plan assets 1,200
Present value of plan obligations (1,100)
100
Adjustment for asset ceiling (40)
Defined benefit balance (before accounting for the
MFR in accordance with IFRIC 14). 60
Liability recognised for MFR (80)
Defined benefit net liability (20)

© Emile Woolf International 236 The Institute of Chartered Accountants of Pakistan

 Chapter 11: IAS 19: Employee benefits

The plan rules allow for a refund of 60% of a surplus. Therefore 40% is not refundable.
X Limited must recognise a liability of Rs. 80m (40% of Rs. 200m). This is netted against the
defined benefit asset of Rs. 60m that would have been recognised in the absence of the
minimum funding requirements.
The amounts in the plan are not available for refund in the future so a liability in respect of the
minimum funding requirement is required.
The impact of paying the MFR amount is as follows:
2016
Rs. m
Defined benefit net liability (20)
Asset arising from payment of MFR 200
Defined benefit net asset 180

Payment of the MFR results in a defined benefit net asset of Rs. 180m.
This is 60% of the original asset of Rs. 100m and the cash introduced (Rs. 200m) as a result
of the MFR.

A defined benefit net liability (indicating a shortfall) might be turned into a net asset by a minimum
funding requirement.

Example: Recognition of liability for a minimum funding requirement

X Limited has a post-employment plan subject to a minimum funding requirement (MFR) as a result
of which it has a statutory obligation to contribute Rs. 300m to the plan as at the reporting date.
The plan rules allow for the refund of 60% of any surplus that arise as per IAS 19.
Year-end valuation of the plan is set out below:

2016
Rs. m
Market value of plan assets 1,000
Present value of plan obligations (1,100)
Defined benefit balance (before accounting for the
MFR in accordance with IFRIC 14). (100)
Liability recognised for MFR (80)
Defined benefit net liability (180)

Payment of the 300 will change the deficit of 100 into a surplus of 200 of which only 120
(60%) is refundable. Therefore, Rs. 80m (40% of Rs. 200m) must be recognised as a liability
resulting in a total defined benefit liability of Rs. 180m.
The impact of paying the MFR amount is as follows:

Defined benefit net liability (180)

Asset arising from payment of MFR 300
Defined benefit net asset 120

Payment of the MFR results in a defined benefit net asset of Rs. 120m.
This is 60% of the surplus that will come into existence when the amount is paid.

© Emile Woolf International 237 The Institute of Chartered Accountants of Pakistan

Advanced accounting and financial reporting

3.4 Consensus – Impact of minimum funding requirement and future benefits available
in the form of a reduction in future contributions
A minimum funding requirement might affect the economic benefit available as a reduction in future
contributions.
When this is the case the minimum funding requirement at a given date must be analysed into
contributions that are required to cover:
 any existing shortfall for past service on the minimum funding basis; and
 future accrual of benefits.
The economic benefit available as a reduction in future contributions when there is a minimum
funding requirement for contributions relating to future service, is the sum of:
 any prepayment that reduces future minimum funding requirement contributions for future
service; and
 the estimated future service cost in each period less the estimated minimum funding
requirement contributions that would be required for future service in those periods if there
were no prepayment as described above.

Example: Recognition of liability for a minimum funding requirement

X Limited has a post-employment plan subject to a minimum funding requirement.
X Limited is required to make contributions over the next three years in respect of an existing
shortfall. The present value of these contributions is Rs. 300m.
It is also required to make further minimum funding payments in the future. The present value of
the difference between these cash flows and the IAS 19 service costs is Rs. 56m.
Year-end valuation of the plan is set out below:

2016
Rs. m
Market value of plan assets 1,000
Present value of plan obligations (1,000)
Defined benefit balance (before accounting for the
MFR in accordance with IFRIC 14). 0
Liability recognised for MFR (300 – 56) (244)
Defined benefit net liability (244)

The liability for the shortfall is Rs. 300m and this should be recognised as a liability. However,
this is reduced by the PV of the economic benefit available in the form of a reduction in future
contributions of Rs. 56m.

© Emile Woolf International 238 The Institute of Chartered Accountants of Pakistan

 Certified Finance and Accounting Professional

12

CHAPTER
Advanced accounting and financial reporting

IFRS 2: Share-based payments

Contents
1 Scope and recognition
2 Equity settled share-based payment transactions: measurement
3 Equity settled share-based payment transactions: expense recognition
4 Modifications to equity settled share-based payment transactions
5 Accounting for cash settled share-based payment transactions
6 Accounting for share-based payment transaction with cash alternatives
7 Disclosures

© Emile Woolf International 239 The Institute of Chartered Accountants of Pakistan

Advanced accounting and financial reporting

1 SCOPE AND RECOGNITION

Section overview

 Introduction
 Scope
 Types of share-based payments
 Recognition
 Grants of share options to employees: the accounting problem

1.1 Introduction
IFRS 2 Share-based payment explains the accounting treatment for share-based payment
transactions.

Definition
A share-based payment transaction is defined as a transaction in which an entity:
a. receives goods or services (e.g. from employees) as consideration for equity instruments of
the entity, or
b. receives goods or services from a supplier by incurring a liability to the supplier for an amount
that is based on the entity’s share price.

1.2 Scope
Included in scope
The IFRS applies to all share-based payment transactions, whether or not the entity can identify
specifically some or all of the goods or services received, including:
(a) equity-settled share-based payment transactions,
(b) cash-settled share-based payment transactions, and
(c) transactions in which an entity acquires or receives goods or services and the terms of the
arrangement provide either the entity or the supplier of those goods or services with a choice
of whether the entity settles the transaction in cash (or other assets) or by issuing equity
instruments,
Excluded from the scope
Transactions with an employee (or other party) in their capacity as a shareholder.
Transactions where equity instruments are issued in exchange for control of a business.
Share-based payment transactions in which the entity receives or acquires goods or services under
a “contract to buy or sell a non-financial item” that is within the scope of IFRS on financial
instruments. (IAS 32 Financial Instrument: Presentation and IFRS 9 Financial Instruments)

1.3 Types of share-based payments

IFRS 2 identifies three types of share-based payment transaction:
 equity-settled share-based payment transactions
 where the entity pays for goods or services by issuing equity instruments including
both:
 shares; and,
 share options;

© Emile Woolf International 240 The Institute of Chartered Accountants of Pakistan

 Chapter 12: IFRS 2: Share-based payments

 cash-settled share-based payment transactions

 where an entity incurs a liability for goods or services and the settlement amount is
based on the price (or value) of the entity’s shares or other equity instruments.
 transactions where an entity acquires goods or receives services and either the entity or the
supplier can choose payment to be:
 a cash amount based on the price (or value) of the entity’s shares or other equity
instruments, or
 equity instruments of the entity
IFRS 2 uses the generic term equity instruments. In most cases the equity instruments in
question are either shares or share options. While, goods include inventories, consumables,
property, plant and equipment, intangible assets and other non-financial assets. IFRS 2 uses the
term fair value in a way that differs in some respects from the IFRS 13 definition. When applying
IFRS 2, fair value is measured in accordance with the guidance in IFRS 2 not that in IFRS 13.

1.4 Recognition
Goods and services must be recognised when the goods and services are received.
This might result in the recognition of an asset or expense depending on the nature of the
transaction. If the goods or services received or acquired in a share-based payment transaction do
not qualify for recognition as assets (determined by rules in other standards), they must be
recognised as expenses.
 if the goods or services are received or acquired through an equity-settled share-based
payment transaction, the entity shall credit the equity by debiting the asset or expense as
the case may be.
 if the goods or services are received or acquired through a cash-settled share-based
payment transaction, the entity shall credit the liability by debiting the asset or expense as
the case may be.

1.5 Grants of share options to employees: the accounting problem

The nature of employee share options
Occasionally, shares may be used instead of cash to pay suppliers for goods or services. These
are described as share-based payments, and until IFRS 2, there was no accounting standard
addressing the recognition and measurement of these transactions.
However, the main reason for the publication of IFRS 2 was to introduce rules of accounting for
employee share options.
In an employee share option scheme, an employee is given the right to subscribe for new shares
in the company at a future date, at a price that is usually fixed when the share options are awarded.
The accounting problem
The award of share options to an employee is a reward for services given by the employee.
 If the employee is rewarded with a cash bonus, the cost of the cash bonus would be included
in total employment costs and charged as an expense in the relevant accounting period.
 A problem in the past with accounting for share options was that although share options are
a similar type of reward for service, the cost of the options were not charged as an expense
in the statement of profit or loss.
An award of share options to an employee is consideration given by the entity to the employee in
return for the employee’s services. Before IFRS 2 was published this was not accounted for.

© Emile Woolf International 241 The Institute of Chartered Accountants of Pakistan

Advanced accounting and financial reporting

As the following sections explain in detail, the IFRS 2 rules on share-based payment result in the
recognition of an expense in profit or loss.
Controversy
When the standard was in its development phase, many argued that there was no expense
because no cash passes hands. However, IFRS 2 is based on the concept that the expenses
represent a consumption of benefit that usually happens to be measured in terms of a cash cost
but need not be in all cases.
The IFRS 2 expense represents the consumption of the benefit of the employees’ service.

© Emile Woolf International 242 The Institute of Chartered Accountants of Pakistan

 Chapter 12: IFRS 2: Share-based payments

2 EQUITY-SETTLED SHARE-BASED PAYMENT TRANSACTIONS:

MEASUREMENT

Section overview

 Introduction
 Direct or indirect measurement
 Measurement date
 Measurement of fair value of equity instruments granted

2.1 Introduction
When an entity acquires goods or receives services it must measure them at fair value with a
corresponding increase in equity.
This raises several issues:
 how should the fair value be measured?
 when should the fair value be measured?
 when should the transaction be recognised?
In answering these questions IFRS 2 distinguishes between:
 transactions with employees (and others providing similar services); and
 transactions with other parties (e.g. suppliers of goods).
The IFRS 2 approach is summarised in the following table:

Transactions with other Transactions with employees

parties
How is the fair value of the With reference to the fair With reference to the fair value
transaction measured? value of the goods and of the equity instrument granted
services received
When is the transaction At the date when the goods At the date when the equity
measured? and services are received instruments are granted
When is the transaction
recognised?
No vesting conditions At date the goods and At grant date
services are received (there is a presumption that the
services have been received in
full)
Vesting conditions As the service is rendered As the service is rendered over
over the vesting period the vesting period

2.2 Direct or indirect measurement

There are two possible approaches which could be followed to measure the fair value of the
transaction:
 estimate the fair value of the debit:
 this is known as direct measurement;
 this uses the fair value of the goods and services themselves;

© Emile Woolf International 243 The Institute of Chartered Accountants of Pakistan

Advanced accounting and financial reporting

 there is a rebuttable presumption that this can be estimated reliably;

 it must be used except for:

 those rare cases in which the fair value of goods and services received
cannot be estimated reliably; and,

 transactions with employees.

 estimate the fair value of the equity instrument credit:
 this is known as indirect measurement;
 this uses the fair value of the equity instruments themselves;
 it must be used:

 when the fair value of goods and services received cannot be estimated
reliably; or

 for transactions with employees.

2.3 Measurement date

The measurement date is the date at which the fair value of the equity instruments granted is
measured for the purposes of this IFRS.
The measurement date is:
 the grant date for transactions with employees (and others providing similar services);
 the date on which goods are obtained or services received for transactions with parties other
than employees (and those providing similar services).

2.4 Measurement of fair value of equity instruments granted

This is needed when the indirect method is being used (i.e. when shares or share options are
granted to employees).
Fair value is measured taking into account all relevant terms and conditions upon which the equity
instruments are granted.
Grant of shares
The market price of the shares is used.
If the shares are not publicly traded an estimated market price should be used adjusted to take into
account the terms and conditions upon which those shares were granted.
Options
The fair value of options granted is measured at the market price of traded options with similar
terms and conditions.
In most cases there will not be a traded option with similar terms and conditions because the
options granted are subject to terms and conditions that do not apply to traded options. For
example, typically, employee share options are:
 non-transferable and
 subject to vesting conditions.
Fair value is then estimated by applying an option pricing model, for example:
 the Black-Scholes-Merton model; or,
 a binomial model.

© Emile Woolf International 244 The Institute of Chartered Accountants of Pakistan

 Chapter 12: IFRS 2: Share-based payments

In applying the model the entity must take into account all relevant factors. These include:
 the exercise price of the option;
 the life of the option;
 the current price of the underlying shares;
 the expected volatility of the share price;
 the dividends expected on the shares;
 the risk-free interest rate for the life of the option;
 vesting conditions that are market conditions.

© Emile Woolf International 245 The Institute of Chartered Accountants of Pakistan

Advanced accounting and financial reporting

3 EQUITY-SETTLED SHARE-BASED PAYMENT TRANSACTIONS: EXPENSE

RECOGNITION

Section overview

 Introduction
 Vesting conditions
 Basic recognition model
 Recognition when there are changes in estimates over the vesting period
 No reversal after equity instruments have vested
 Market conditions

3.1 Introduction
Often, when equity instruments are granted they are subject to conditions that must be satisfied
before the counterparty becomes unconditionally entitled to the instrument.
 These are known as vesting conditions.
 The period during which the vesting conditions are met is called the vesting period.
No vesting conditions
If the counterparty is not required to complete a specified period of service before becoming
unconditionally entitled to the equity instruments they are said to vest immediately.
In the absence of evidence to the contrary, the entity must presume that services rendered by the
counterparty as consideration for the equity instruments have been received.
In this case the entity must recognise the services received in full on the grant date.

3.2 Vesting conditions

IFRS 2 distinguishes different categories of “vesting condition”. These are:
 service conditions which require the counterparty to complete a specified period of service
before the option vests; and
 performance conditions which require the counterparty to complete a specified period of
service and specified performance targets to be met.
There are two broad categories of performance targets:
 market conditions; and
 non-market conditions
This distinction is very important. The probability of achieving each type of condition affects the
accounting treatment of equity-settled share-based payments but in different ways.

Market conditions Non-market conditions

Definition Any condition that relates to share It is based on the entity’s
price. operations or activities.
Examples Increase in share price to a specified Increase in profitability to a
value. specified amount.
Total shareholder return to a specified Launch of a new product.
percentage (total shareholder return Achieving quality improvement.
refers to dividends and share value)

© Emile Woolf International 246 The Institute of Chartered Accountants of Pakistan

 Chapter 12: IFRS 2: Share-based payments

Market conditions Non-market conditions

How the Probability of meeting the condition is Probability of meeting the condition
probability of a measurement attribute. is a recognition attribute.
achieving the Probability of meeting the condition is Probability of meeting the condition
condition affects taken into account when measuring plays no part in measuring the fair
the accounting the fair value of the instrument at the value of the instrument at the grant
treatment. grant date. date.
Subsequent changes in the Subsequent changes in the
probability of meeting the condition probability of meeting the condition
have no impact and are ignored. have no impact and are ignored.
Impact of the Probability of meeting the condition is Probability of meeting the condition
probability of a measurement attribute. is a recognition attribute.
achieving the
condition on the
accounting
treatment.
Probability of meeting the condition is Probability of meeting the condition
taken into account when measuring plays no part in measuring the fair
the fair value of the instrument at the value of the instrument at the grant
grant date. date.
Subsequent changes in the Subsequent changes in the
probability of meeting the condition probability of meeting the condition
have no impact and are ignored. are taken into account in
estimating the expense to be
recognised.

For clarity
A market condition is any condition that relates to share price. Any other type of condition is non-
market.
For example, a performance condition might be that the shares will vest as long as an employee
stays with the company for three years from the grant date and the share price increases by 20%
in this period.
The probability of achieving a market condition is taken into account when estimating the fair value
of the equity instrument granted. Subsequent changes in this probability play no part in the
recognition.
For clarity, this means that an option may not vest due to failure to meet the market condition but
an expense is recognised as if the condition had been met.

3.3 Basic recognition model

A vesting period will usually cover several reporting periods.
If a grant of share options is conditional upon the completion of three years’ service, recognition is
based on the assumption that the services rendered by the employee in consideration for these
share options will be received over that three-year vesting period.
The fraction of the total equity-settled share based payment expense that relates to a reporting
period is recognised in that reporting period. This continues until the end of the vesting reporting
period.

© Emile Woolf International 247 The Institute of Chartered Accountants of Pakistan

Advanced accounting and financial reporting

Example: Equity settled share-based payment

X Limited is a company with a 31 December year end.
On 1 January Year 1, X Limited grants 100 options to each of its 500 employees.
Each grant is conditional upon the employee working for X Limited over the next three years.
At the grant date the fair value of each option is Rs.15.
X Limited estimates that 20% of employees will leave over the vesting period (i.e. 80% of
employees will receive the equity instruments).
Assuming that the estimate of the leavers does not change and is correct (i.e. 80% of employees
become entitled to the equity instruments at the end of the vesting period), expense recognition
over the vesting period is as follows:
Amount recognised each year: Rs.
(80%  500) employees  100 options  Rs.15  1/3 200,000

Double entry in each year Dr Cr

Statement of profit or loss 200,000
Equity 200,000
Balance accumulated in equity at end of:
year 1 200,000
year 2 400,000
year 3 600,000

There is no requirement to set up a separate reserve in equity for the completion of the double
entry. Although an entity might do this, many companies in practice complete the double entry into
retained profits.

3.4 Recognition when there are changes in estimates over the vesting period
The above example is based on the assumption that there is no change in the estimate of the
number of leavers over the vesting period and that the estimate turns out to be correct. This is
rarely the case. A number of variables might change the estimated total expense at each year-end
including:
 the number of employees expected to meet the service condition;
 the number of options to which the employees will become entitled
 the length of the vesting period.
Changes in estimate of the outcome of the service and non-market performance conditions are
taken into account in the calculation of the number of equity instruments that are expected to vest
at the end of the vesting period.
The necessary expense is calculated as follows.
Step 1: At each year end an entity must estimate the total expense expected to arise in respect of
a grant of equity instruments by the end of the vesting period.
 At each year end an entity must make the best available estimate of the number of equity
instruments expected to vest taking account of non-market vesting conditions (including
service conditions and non-market performance conditions).
 The number of shares is then valued using the fair value at the grant date.

© Emile Woolf International 248 The Institute of Chartered Accountants of Pakistan

 Chapter 12: IFRS 2: Share-based payments

Step 2: The entity then estimates the fraction of this total amount that relates to the vesting period
to date. For example, if the total expected expense by the end of the 3 year vesting period is
Rs.1,500,000 and it is the end of the second year, then only Rs. 1,000,000 (2/3 of the total) relates
to the vesting period to date.
Step 3: The annual expense is the calculated by comparing the total that relates to the vesting
period to date to the amount previously recognised.
The difference is recognised as an expense:
On rare occasions the process might show that the total expense relating to the vesting period to
date is smaller than that previously recognised. In that case the previously recognised expense is
reversed as follows:

Illustration: Equity-settled share-based payment reversal of expense

Debit Credit
Equity X
Statement of profit or loss X

At the vesting date the actual number of equity instruments that vest (or that would have vested
except for the failure of a market condition) is the basis for the overall cumulative charge (and the
corresponding balance in equity).
Ultimately, the amount recognised for goods or services received as consideration for the equity
instruments granted is based on the number of equity instruments that eventually vest (or that
would have vested except for the failure of a market condition – see below)
No amount is recognised on a cumulative basis for goods or services received if the equity
instruments granted do not vest because of failure to satisfy non-market vesting conditions.
Grant with changes in the probability of meeting the service condition
The estimated total expense is revised at the end of each reporting period to take account of the
estimate of the number of employees expected to meet the service condition. (This is sometimes
described as truing up).

Example: Equity-settled share-based payment

X Limited is a company with a 31 December year end.
1 January Year 1
X Limited grants 100 options to each of its 500 employees.
Each grant is conditional upon the employee working for X Limited over the next three years.
At the grant date the fair value of each option is Rs.15.
31 December Year 1
X Limited estimates that 20% of employees will leave over the vesting period (including those who
have actually left in year 1).
The expense recognised at the end of year 1 is as follows:
Year 1 expense Rs.
(80%  500) employees  100 options  Rs.15  1/3 200,000
Amount previously recognised -
Year 1 expense 200,000

© Emile Woolf International 249 The Institute of Chartered Accountants of Pakistan

Advanced accounting and financial reporting

31 December Year 2
X Limited estimates that only 15% of employees will leave over the vesting period (including those
who have actually left in years 1 and 2).
The expense recognised at the end of year 2 is as follows:

Year 2 expense Rs.

(85%  500) employees  100 options  Rs.15  2/3 425,000

Amount previously recognised (200,000)

Year 2 expense 225,000

31 December Year 3
418 employees satisfy the service condition.
The expense recognised at the end of year 3 is as follows:

Year 3 expense Rs.

418 employees  100 options  Rs.15  3/3 627,000

Amount previously recognised (425,000)

Year 3 expense 202,000

Practice question 1
X Limited is a company with a 31 December year end.
On 1 January Year 1 X Limited grants 100 options to each of its 500 employees.
Each grant is conditional upon the employee working for X Limited over the next three years.
At the grant date X Limited estimates that the fair value of each option is Rs.15.
Required:
Calculate the income statement charge for the year ended:
1. 31 December Year 1 if at that date, X Limited expects 85% of employees to be with
the company at the end of the vesting period.
2. 31 December Year 2 if at that date, X Limited expects 88% of employees to be with
the company at the end of the vesting period.
3. 31 December Year 3 if at that date 44,300 share options vest.

Grant with a non-market performance condition in which the length of the vesting period could vary
If a grant of share options is conditional on staying with an entity until a non-market performance
condition is achieved the length of the vesting period could vary.
The length of the expected vesting period is estimated at grant date and revised if subsequent
information indicates that the length of the vesting period differs from previous estimates (but not
if the performance condition is a market condition).

© Emile Woolf International 250 The Institute of Chartered Accountants of Pakistan

 Chapter 12: IFRS 2: Share-based payments

Example: Performance condition where the length of the vesting period could vary
X Limited is a company with a 31 December year end.
1 January Year 1
X Limited grants 10,000 shares to each of its 10 directors on condition that they remain with the
company in the vesting period and subject to the following performance condition.
The shares will vest at:
a. 31 December Year 1 if X Limited’s earnings grow by 20% or more; or
b. 31 December Year 2 if X Limited’s earnings grow by an average of 15% or more over the
two years; or
c. 31 December Year 3 if X Limited’s earnings grow by an average of 12% or more over the
three years.
At the grant date X Limited estimates that the fair value of each share is Rs. 50.

31 December Year 1
Earnings have grown by 16% therefore the shares do not vest at this date.
X Limited makes the following estimates:
a) earnings will increase at 16% in the next year with the result that the shares are expected
to vest at the next year-end (because the average growth would be over 15%).
b) 9 directors are expected to be with the company at that time.

Year 1 expense Rs.

9 directors  10,000  Rs. 50  1/2 2,250,000
Amount previously recognised -
Year 1 expense 2,250,000
31 December Year 2
Earnings have grown by 10% giving an average growth of 13% (16% + 10%)/2 years). This is less
than the 15% specified as a performance condition therefore the shares do not vest at this date.
X Limited makes the following estimates:
a) earnings will increase at 10% in the next year resulting in an average growth rate of 12%
((16% + 10% + 10%)/3 years) so the shares are expected to vest at the next year end.
b) 9 directors are expected to be with the company at that time.

Year 2 expense Rs.

9 directors  10,000  Rs. 50  2/3 3,000,000
Amount previously recognised (2,250,000)
Year 2 expense 750,000
31 December Year 3
Earnings have grown by 15% resulting in an average growth rate of 13.7% ((16% + 10% + 15%)/3
years) so the shares vest.
There are 8 directors who receive shares.

Year 3 expense Rs.

8 directors  10,000  Rs. 50  3/3 4,000,000
Amount previously recognised (3,000,000)
Year 3 expense 1,000,000

© Emile Woolf International 251 The Institute of Chartered Accountants of Pakistan

Advanced accounting and financial reporting

Grant with a non-market performance condition in which the number of equity instruments to which
the employees become entitled could vary

Example: Performance condition where the number of equity instruments could vary
X Limited is a company with a 31 December year end.
1 January Year 1
X Limited grants share options to each of its 10 directors on condition that they remain with the
company over a 3 year vesting period and subject to the following performance condition.
a) Each director will receive 5,000 share options if profit grows by an average of 10% to 15%
per annum over the 3 year period.
b) Each director will receive 10,000 share options if profit grows by an average of at least 15%
to 20% per annum over the 3 year period.
c) Each director will receive 15,000 share options if profit grows by an average of over 20% per
annum over the 3 year period.
At the grant date X Limited estimates that the fair value of each share is Rs. 50.

31 December Year 1
Profit has grown by 17% in Year 1.
X Limited makes the following estimates:
a) Profit will continue to increase by at least 16% over the vesting period.
b) 9 directors are expected to be with the company at the end of the vesting period.
Year 1 expense Rs.
9 directors  10,000  Rs. 50  1/3 1,500,000
Amount previously recognised -
Year 1 expense 1,500,000
31 December Year 2
Profit has grown by 23% in Year 2 giving an average growth of 20% (17% + 23%)/2 years).
X Limited makes the following estimates:
a) Profit will increase by at least 20% next year.
b) 9 directors are expected to be with the company at the end of the vesting period.
Year 2 expense Rs.
9 directors  15,000  Rs. 50  2/3 4,500,000
Amount previously recognised (1,500,000)
Year 2 expense 3,000,000

31 December Year 3
Profit grew by 18% in Year 3 giving an average growth of 18.3% (17% + 23% +18%/3 years).
Therefore each director receives 10,000 share options.
There are 8 directors who receive shares.

Year 3 credit Rs.

8 directors  10,000  Rs. 50  3/3 4,000,000
Amount previously recognised (4,500,000)
Year 3 credit (500,000)

© Emile Woolf International 252 The Institute of Chartered Accountants of Pakistan

 Chapter 12: IFRS 2: Share-based payments

In this case, a previously recognised expense is reversed in year 3 as follows:

Dr Cr
Equity 500,000
Statement of profit or loss 500,000

3.5 No reversal after equity instruments have vested

Once goods or services have been recognised in accordance with IFRS 2 (with a corresponding
increase in equity) an entity is not allowed to adjust total equity.
For example an entity is not allowed to reverse the transaction if options are not exercised perhaps
because they are out of the money (i.e. where the exercise price is greater than the share value).
However an entity is allowed to recognise a transfer from one component of equity to another.
3.6 Market conditions
As explained earlier any condition that relates to share values is a market condition and the
probability of achieving such a condition is a measurement attribute rather than a recognition
attribute. This means that it is taken into account in the initial grant date valuation of the equity
instrument and that subsequent changes in the probability of achieving the condition have no effect
on the expense recognition.

Example: Equity settled share-based payment with market condition

X Limited is a company with a 31 December year end.
X Limited grants 10,000 share options to each of its 10 directors on condition that they remain
with the company over a 3 year vesting period and that share price increases by 10% per annum
over that period.
At the grant date the fair value of each share option (taking account of the probability of achieving
the share price increase) is Rs. 40.
Early in Year 1, X Limited’s profitability was adversely affected by a fall in world oil price making it
extremely unlikely that the share price condition will be met. This has no impact on the recognition
of the expense which proceeds as follows:
31 December Year 1
9 directors are expected to be with the company at the end of the vesting period.
The expense recognised at the end of year 1 is as follows:

Year 1 expense Rs.

9 directors  10,000 options  Rs. 40  1/3 1,200,000
Amount previously recognised -
Year 1 expense 1,200,000

31 December Year 2
9 directors are expected to be with the company at the end of the vesting period.
The expense recognised at the end of year 2 is as follows:

Year 2 expense Rs.

9 directors  10,000 options  Rs. 40  2/3 2,400,000
Amount previously recognised (1,200,000)
Year 2 expense 1,200,000

© Emile Woolf International 253 The Institute of Chartered Accountants of Pakistan

Advanced accounting and financial reporting

31 December Year 3
8 directors are still employed by the company.
The share price condition is not met.
The expense recognised at the end of year 3 is as follows:

Year 3 expense Rs.

8 directors  10,000 options  Rs. 40  3/3 3,200,000
Amount previously recognised (2,400,000)
Year 3 expense 800,000

Grant with a market performance condition where the date on which the target is achieved might
vary
If a grant of share options is conditional on staying with an entity until a market performance
condition is achieved the time taken to achieve the target could vary.
The length of the expected vesting period is estimated at grant date and is not revised
subsequently.

Example: Performance condition where the length of the vesting period could vary
X Limited is a company with a 31 December year end.
1 January Year 1
X Limited grants 10,000 shares to each of its 10 directors on condition that they remain with the
company in the vesting period and subject to the following performance condition.
The shares vest when the share price increases by 50% above its value at the grant date. It is
estimated that this will occur in 4 years after the grant date.
At the grant date X Limited estimates that the fair value of each share is Rs. 50.
X Limited estimates that all 10 directors will remain with the firm.
The following amounts will be recognised as an expense in each of the next 4 years.

10 directors  10,000 options  Rs. 50  1/4 Rs. 1,250,000

Note that the date at which the increase in share value is actually achieved is irrelevant.
The original estimate of the length of the vesting period is not revised. (This is different
from cases involving non-market conditions).

© Emile Woolf International 254 The Institute of Chartered Accountants of Pakistan

 Chapter 12: IFRS 2: Share-based payments

4 MODIFICATIONS TO EQUITY-SETTLED SHARE-BASED PAYMENT

TRANSACTIONS

Section overview

 Introduction
 Modifications that increase the fair value of the equity instruments granted
 Modification that increase the number of equity instruments granted
 Modifications that decrease the total fair value of the share-based arrangement
 Modification to reduce the vesting period
 Cancellation

4.1 Introduction
The terms and conditions upon which an option was granted may be modified subsequently. For
example, the entity might reduce the exercise price of options granted to employees (i.e. reprice
the options), which increases the fair value of those options.
Any changes to the terms and conditions on which the options were granted must be taken into
account when measuring the services received.
Background
As a minimum an entity must recognise services received measured at the grant date fair value of
the equity instruments granted, unless those equity instruments do not vest because of failure to
satisfy a non-market vesting condition.
In addition, the entity must recognise the effects of modifications that increase the total fair value
of the share-based payment arrangement or are otherwise beneficial to the employee. In other
words, modifications that are unfavourable for employees are ignored while favourable
modifications are accounted for.

4.2 Modifications that increase the fair value of the equity instruments granted
The entity must calculate the incremental fair value of the equity instruments brought about by the
modification.
This incremental fair value is included in the measurement of the amount recognised for services
received as consideration for the equity instruments granted.
The incremental fair value granted is calculated as the difference between the following as at the
date of the modification:
 the fair value of the modified equity instrument; and
 that of the original equity instrument, both estimated as at the date of the modification.
When a modification occurs during the vesting period the incremental fair value granted is included
in the measurement of the amount recognised over the period from the modification date until the
date when the equity instruments vest. This is in addition to the amount based on the grant date
fair value of the original equity instruments, which is recognised over the remainder of the original
vesting period.

© Emile Woolf International 255 The Institute of Chartered Accountants of Pakistan

Advanced accounting and financial reporting

Example: Modification – reduction of exercise price

X Limited is a company with a 31 December year end.
1 January Year 1
X Limited granted 1,000 share options at an exercise price of Rs. 50 to each of its 30 key
management personnel.
The options vest if the managers were still employees on 31 December Year 4.
The fair value of the share options was estimated at Rs. 20.
31 December Year 1
X Limited estimated that the options will vest with 20 managers.
Year 1 expense Rs.
20 managers  1,000 options  Rs. 20  ¼ 100,000
Amount previously recognised -
Year 1 expense 100,000

1 July Year 2
X Limited’s share price collapsed early in Year 2.
On 1 July Year 2 X Limited modified the share option scheme by reducing the exercise price to Rs.
15.
The fair value of an option was Rs. 2 immediately before the price reduction and Rs. 11
immediately after.
31 December Year 2
X Limited estimates that the options will vest with 20 managers.
The expense recognised at the end of year 2 is as follows:
Year 2 expense Rs.
Original grant
20 managers  1,000 options  Rs. 20  2/4 200,000
Modification
20 managers  1,000 options  (Rs. 11 – Rs. 2)  0.5/2.5* 36,000
236,000
Amount previously recognised (100,000)
Year 2 expense 136,000
* At the date of the modification there were 6 months to the year-end and 2 years
and 6 months to the vesting date
31 December Year 3
X Limited estimates that the options will vest with 20 managers.
The expense recognised at the end of year 3 is as follows:
Year 3 expense Rs.
Original grant
20 managers  1,000 options  Rs. 20  3/4 300,000
Modification
20 managers  1,000 options  (Rs. 11 – Rs. 2)  1.5/2.5 108,000
408,000
Amount previously recognised (236,000)
Year 3 expense 172,000

© Emile Woolf International 256 The Institute of Chartered Accountants of Pakistan

 Chapter 12: IFRS 2: Share-based payments

Year 4 expense Rs.

Original grant
20 managers  1,000 options  Rs. 20  4/4 400,000
Modification
20 managers  1,000 options  (Rs. 11 – Rs. 2)  2.5/2.5 180,000
Amount previously recognised 580,000
Amount previously recognised (408,000)
Year 4 expense 172,000

In summary, the original grant is accounted for as if nothing had happened and the modification
results in a new expense. The annual expenses could have been calculated as follows:

Example: Modification – reduction of exercise price

All facts as above.

Original grant – expense in years 1 to 4 Rs.

20 managers  1,000 options  Rs. 20  1/4 100,000

Modification – expense in year 2 Rs.

20 managers  1,000 options  (Rs. 11 – Rs. 2)  0.5/2.5 36,000

Modification – expense in years 3 and 4 Rs.

20 managers  1,000 options  (Rs. 11 – Rs. 2)  1/2.5 72,000

Summary Year 1 Year 2 Year 3 Year 4

Original grant 100,000 100,000 100,000 100,000
Modification  36,000 72,000 72,000
Annual expense 100,000 136,000 172,000 172,000

4.3 Modification that increase the number of equity instruments granted

This is similar to the above.
The fair value of the additional equity instruments granted (measured at the date of the
modification) is included in the measurement of the amount recognised for services received as
consideration for the equity instruments granted.
When a modification occurs during the vesting period the fair value of the additional equity
instruments granted is included in the measurement of the amount recognised for services
received over the period from the modification date until the date when the additional equity
instruments vest. This is in addition to the amount based on the grant date fair value of the equity
instruments originally granted, which is recognised over the remainder of the original vesting
period.

© Emile Woolf International 257 The Institute of Chartered Accountants of Pakistan

Advanced accounting and financial reporting

Example: Modification – reduction of exercise price

X Limited is a company with a 31 December year end.
1 January Year 1
X Limited grants 1,000 shares for no consideration to its CEO subject to a 3 year service condition.
At grant date the fair value of the shares is Rs. 15.
During the year, the share price decreases significantly.
1 January Year 2
The share price is Rs. 5.
X Limited grants an additional 2,000 shares for no consideration worth Rs. 10,000 to compensate
the CEO for the price fall of Rs. 10 per share.
Original grant – expense in years 1 to 3 Rs.
1 CEO  1,000 shares  Rs. 15  1/3 5,000

Modification – expense in years 2 to 3 Rs.

1 CEO  2,000 shares  Rs. 5  1/2 5,000

Summary Year 1 Year 2 Year 3

Original grant 5,000 5,000 5,000
Modification  5,000 5,000
Annual expense 5,000 10,000 10,000

4.4 Modifications that decrease the total fair value of the share-based arrangement
In effect such modifications are ignored. The entity must continue to account for the services
received as consideration for the equity instruments granted as if that modification had not
occurred.

4.5 Modification to reduce the vesting period

Expense recognition is accelerated over the new vesting period.

Example: Modification – reduction of vesting period

X Limited is a company with a 31 December year end.
1 January Year 1
X Limited grants 1,000 share options to its finance director subject to a 5 year service condition.
The grant date fair value of a share option is Rs. 10.
1 July Year 2
X Limited reduces the service period to 4 years.
The finance director remains in service over the five year period.
The following amounts will be recognised as an expense in each of the next 4 years.
Expense in year 1 Rs.
1  1,000 options  Rs. 10  1/5 2,000

Expense in year 2 Rs.

1  1,000 options  Rs. 10  2/4 5,000
Amount previously recognised (2,000)
Year 2 expense 3,000

© Emile Woolf International 258 The Institute of Chartered Accountants of Pakistan

 Chapter 12: IFRS 2: Share-based payments

Expense in year 3 Rs.

1  1,000 options  Rs. 10  3/4 7,500
Amount previously recognised (5,000)
Year 3 expense 2,500

Expense in year 4 Rs.

1  1,000 options  Rs. 10  4/4 10,000
Amount previously recognised (7,500)
Year 4 expense 2,500

4.6 Cancellation
A cancellation is accounted for as an acceleration of vesting. The amount that would otherwise
have been recognised over the vesting period is recognised immediately.

Example: Cancellation
X Limited is a company with a 31 December year-end.
1 January Year 1
X Limited grants 100 options to each of its 500 employees.
Each grant is conditional upon the employee working for X Limited over the next five years.
The grant date fair value of each option is Rs. 10.
31 December Year 1
X Limited expects 20% of employees to leave over the vesting period.
The expense recognised at the end of year 1 is as follows:
Year 1 expense Rs.
(80%  500 employees)  100 options  Rs. 10  1/5 80,000
Amount previously recognised nil
Year 1 expense 80,000

31 December Year 2
X Limited expects 20% of employees to leave over the vesting period
The expense recognised at the end of year 2 is as follows:
Year 2 expense Rs.
(80%  500 employees)  100 options  Rs. 10  2/5 160,000
Amount previously recognised (80,000)
Year 2 expense 80,000

Year 3
X Limited cancelled the scheme when 460 employees were still in the scheme.
The expense recognised at the end of year 3 is as follows:
Year 3 expense Rs.
460  100 options  Rs. 10  5/5 460,000
Amount previously recognised (160,000)
Year 3 expense 300,000

© Emile Woolf International 259 The Institute of Chartered Accountants of Pakistan

Advanced accounting and financial reporting

Cancellation with cash compensation

An entity may make a payment to the employee in compensation for the cancellation.
Such a payment is accounted for as the repurchase of an equity interest and deducted
from equity. However if the payment exceeds the fair value of the equity instruments
repurchased any excess is recognised as an expense.
Example: Cancellation with payment to the employee
X Limited is a company with a 31 December year-end.
1 January, Year 1
X Limited granted 1,000 share options to an employee subject to a 3 year service condition.
The grant date fair value of each option was Rs. 9.
31 December, Year 2
Fair value of each share option is Rs. 18.
X Limited offered to cancel the arrangement in return for a pro rata cash compensation based on
the current fair value that reflects the proportion of the services provided to the services required
under the plan.
The offer amounts to Rs. 12,000 (1,000 x 18 x 2/3).
The employee accepted the offer and payment was made immediately.
The expense for each of the two years is as follows:

Year 1 expense Rs.

Amount to be recognised by end of year 1:
1,000 options  Rs.9  1/3 3,000
Amount previously recognised -
Year 1 expense 3,000

Year 1 double entry Debit Credit

Statement of profit or loss 3,000
Equity 3,000

Year 2 expense Rs.

Amount to be recognised by end of year 2:
1,000 options  Rs.9  2/2 9,000
Amount previously recognised (3,000)
Year 2 expense 6,000

Year 2 double entry Debit Credit

Statement of profit or loss 6,000
Equity 6,000

The cash payment would be accounted for as follows:

Equity 12,000
Cash 12,000

© Emile Woolf International 260 The Institute of Chartered Accountants of Pakistan

 Chapter 12: IFRS 2: Share-based payments

Cancellation with new grant identified as a replacement award

An entity may grant new equity instruments to the employee and identify them as a replacement
for those cancelled on the date when those new equity instruments are granted. When this happens
the grant of the new instruments is accounted for in the same way as a modification.
The incremental fair value granted is calculated at the date the replacement equity instruments are
granted as the difference between:
 the fair value of the replacement equity instruments; and
 the net fair value of the cancelled equity instruments which is:
 the fair value of the cancelled instruments immediately before the cancellation, less
 the amount of any payment made to the employee on cancellation of the equity
instruments that is accounted for as a deduction from equity.

Example: Cancelation with replacement award

X Limited is a company with a 31 December year-end.
1 January Year 1
X Limited grants 1,000 share options to its CEO subject to a 4 year service condition.
The grant date fair value of each share option is Rs. 8.
1 January Year 3
The fair value of the share options has decreased to Rs. 3.
In order to restore the economic position of the CEO, X Limited cancels the original award and
grants a new award as a replacement.
The new grant is for 1,000 share options with a fair value at date of replacement of Rs. 8 subject
to a remaining service period until the end of the original vesting period (i.e. 31 December Year 4
being 2 years after the replacement date).
X Limited identifies the new award as a replacement award for the original award. The incremental
fair value per equity instrument is Rs. 5 (Rs. 8  Rs. 3).
The annual expenses are as follows:

Original grant – expense in years 1 to 4 Rs.

1 CEO  1,000 options  Rs. 8  1/4 2,000

Modification – Replacement award in years 3 and 4 Rs.

1 CEO  1,000 options  (Rs. 8 – Rs. 3)  1/2 2,500

Summary Year 1 Year 2 Year 3 Year 4

Original grant 2,000 2,000 2,000 2,000
Modification   2,500 2,500
Annual expense 2,000 2,000 4,500 4,500

© Emile Woolf International 261 The Institute of Chartered Accountants of Pakistan

Advanced accounting and financial reporting

Cancellation with new grant not identified as a replacement award

If the new grant is not identified as a replacement award the first grant is accounted for as a
cancellation and the new grant accounted for in the usual way.

Example: Cancelation with new grant not identified as a replacement award

X Limited is a company with a 31 December year-end.
1 January Year 1
X Limited grants 1,000 share options to its CEO subject to a 4 year service condition.
The grant date fair value of each share option is Rs. 8.
1 January Year 3
The fair value of the share options has decreased to Rs. 3.
In order to restore the economic position of the CEO, X Limited cancels the original award and
grants a new award not specifically identified as a replacement for the now cancelled award.

The new grant is for 1,000 share options with a fair value at date of replacement of Rs. 8 subject
to a remaining service period until the end of the original vesting period (i.e. 31 December Year 4
being 2 years after the replacement date).
The annual expenses are as follows:

Original grant – expense in year 1 Rs.

1 CEO  1,000 options  Rs. 8  1/4 2,000

Original grant – expense in year 2 (cancellation) Rs.

1 CEO  1,000 options  Rs. 8  4/4 8,000

Amount previously recognised (2,000)

Year 2 expense 6,000

Modification – New grant in years 3 and 4 Rs.

1 CEO  1,000 options  Rs. 8  1/2 4,000

Summary Year 1 Year 2 Year 3 Year 4

Original grant 2,000 8,000  

Modification   4,000 4,000

Annual expense 2,000 8,000 4,000 4,000

© Emile Woolf International 262 The Institute of Chartered Accountants of Pakistan

 Chapter 12: IFRS 2: Share-based payments

5 ACCOUNTING FOR CASH-SETTLED SHARE-BASED PAYMENT

TRANSACTIONS

Section overview

 Introduction
 Share appreciation scheme
 Treatment of vesting and non-vesting conditions

5.1 Introduction
A cash-settled share-based payment transactions is where an entity incurs a liability for goods and
services and the settlement amount is based on the price (or value) of the entity’s shares or other
equity instruments.
The basic rules are:
 The liability incurred is measured at its fair value at each reporting date until it is settled.
(There is no locking of fair value at grant date).
 Any change in the fair value of the liability is recognised in profit or loss.

5.2 Share appreciation scheme

An entity might grant share appreciation rights to employees as part of their pay package,
whereby the employees will become entitled to a future cash payment (rather than an equity
instrument), based on the increase in the entity’s share price from a specified level over a
specified period of time.
Immediate recognition
An entity must recognise services received, and a liability to pay for those services, as the
employees render service.
Some share appreciation rights vest immediately (the employees are not required to complete a
specified period of service to become entitled to the cash payment).
 In the absence of evidence to the contrary, the entity must presume that the services
rendered by the employees in exchange for the share appreciation rights have been received
 The entity must recognise immediately the services received and a liability to pay for them.
Recognition over a period
Some share appreciation schemes do not vest until the employees have completed a specified
period of service.
The entity must recognise the services received, and a liability to pay for them, as the employees
render service during that period.
Measurement
The liability is measured, initially and at each reporting date until settled, at the fair value of the
share appreciation rights.
This is done by applying an option pricing model, taking into account:
 the terms and conditions on which the share appreciation rights were granted, and
 the extent to which the employees have rendered service to date.
If the share appreciation rights granted are conditional upon the employees’ remaining in the
entity’s employ for the next three years and the employees have completed only one year’s service
at the reporting date, the entity must measure the fair value of the liability at the reporting date and
multiplying the resulting amount by one-third.

© Emile Woolf International 263 The Institute of Chartered Accountants of Pakistan

Advanced accounting and financial reporting

Example: Cash-settled share-based payment transaction

X Limited is a company with a 31 December year end.
1 January Year 1
X Limited grants 100 cash share appreciation rights (SARs) to each of its 500 employees.
Each grant is conditional upon the employee working for X Limited over the next three years.

Further information
Actual leavers Estimate of further
in the year leavers in the future
Year 1 20 40
Year 2 30 30
Year 3 25 -

The entity estimates the fair value of the SARs at the end of each year in which a liability exists as
shown below.

Year Fair value

1 15
2 18
3 20
4 23
5 25

As at 31 December Year 5 the employees had not exercised their rights to receive cash.
The number of employees whose interest is expected to vest and whose interest does is as follows:

Number of employees whose interest is expected to vest

Year 1 Year 2 Year 3

Number at grant date 500 500 500
Number of leavers in year 1 20 20 20
Number of leavers in year 2  30 30
Number of leavers in year 3   25
Expected future number of leavers 40 30 
Total expected leavers (60) (80)
Actual leavers (75)
Expected to vest 440 420
Actually vest 425

© Emile Woolf International 264 The Institute of Chartered Accountants of Pakistan

 Chapter 12: IFRS 2: Share-based payments

Example: Cash-settled share-based payment transaction

The closing liability and the expense recognised at each year end are as follows:
31 December Year 1

Year 1 expense Rs.

Liability b/f -
Year 1 expense (balancing figure) 220,000
Liability c/f:
440 employees (W)  100 options  Rs.15  1/3 220,000

31 December Year 2
Year 2 expense Rs.
Liability b/f 220,000
Year 2 expense (balancing figure) 284,000
Liability c/f:
420 employees (W)  100 options  Rs.18  2/3 504,000

31 December Year 3
Year 3 expense Rs.
Liability b/f 504,000
Year 3 expense (balancing figure) 346,000
Liability c/f:
425 employees (W)  100 options  Rs.20  3/3 850,000

31 December Year 4
Year 4 expense Rs.
Liability b/f 850,000
Year 4 expense (balancing figure) 127,500
Liability c/f:
425 employees (W)  100 options  Rs.23  3/3 977,500

31 December Year 5
Year 5 expense Rs.
Liability b/f 977,500
Year 5 expense (balancing figure) 85,000
Liability c/f:
425 employees (W)  100 options  Rs.25  3/3 1,062,500

The liability is reduced as the company pays out cash to employees who exercise their rights.

© Emile Woolf International 265 The Institute of Chartered Accountants of Pakistan

Advanced accounting and financial reporting

Example: Cash-settled share-based payment transaction

X Limited is a company with a 31 December year end.
1 January Year 1
X Limited grants 100 cash share appreciation rights (SARs) to each of its 500 employees.
Each grant is conditional upon the employee working for X Limited over the next three years.

Further information
Actual leavers Estimate of further
in the year leavers in the future
Year 1 20 40
Year 2 30 30
Year 3 25 -
The fair values of the SARs at the end of each year in which a liability exists and the intrinsic values
of the SARs (which equals the cash paid to the employees) are shown below.
Year Fair value Intrinsic value
1 15
2 18
3 20 16
4 23 22
5 25 24
Employees cashed in their SARs as follows:
Year Employees
3 100
4 125
5 200
The number of employees whose interest is expected to vest and whose interest does vest is as
before (shown in the previous example).
The closing liability and the expense recognised at each year end are as follows:
31 December Year 1
Year 1 expense Rs.
Liability b/f -
Year 1 expense (balancing figure) 220,000
Liability c/f:
440 employees  100 options  Rs.15  1/3 220,000

31 December Year 2
Year 2 expense Rs.
Liability b/f 220,000
Year 2 expense (balancing figure) 284,000
Liability c/f:
420 employees  100 options  Rs.18  2/3 504,000

31 December Year 3
Year 3 expense Rs.
Liability b/f 504,000
Cash paid (100 employees  100 options  Rs.16) (160,000)
Year 3 expense (balancing figure) 306,000
Liability c/f
325 employees (W below)  100 options  Rs.20  3/3 650,000

© Emile Woolf International 266 The Institute of Chartered Accountants of Pakistan

 Chapter 12: IFRS 2: Share-based payments

31 December Year 4
Year 4 expense Rs.
Liability b/f 650,000
Cash paid (125 employees  100 options  Rs.22) (275,000)
Year 4 expense (balancing figure) 85,000
Liability c/f:
200 employees (W below)  100 options  Rs.23  3/3 460,000

31 December Year 5
Year 5 expense Rs.
Liability b/f 460,000
Cash paid (200 employees  100 options  Rs.24) (480,000)
Year 5 expense (balancing figure) 20,000
Liability c/f:
Nil employees  100 options  Rs.25  3/3 

Note: The total expense over the 5 year period is equal to the cash paid.

Example (continued): Cash settled share-based payment

W: Number of employees with vested interest

Year 3 Year 4 Year 5
Number vested 425 425 425
Number cashing out in year 3 100 100 100
Number cashing out in year 4  125 125
Number cashing out in year 5   200
(100) (225) (425)
Employees with unexercised rights 325 200 

5.3 Treatment of vesting and non-vesting conditions

Like equity settled share based payments, cash settled share based payments can also be
conditional upon the vesting conditions (market condition) and non-vesting conditions (non market
conditions)
Non vesting conditions shall
 not be taken into account while estimating the fair value of cash settled share based payment
at measurement date
 be taken into account by adjusting the number of awards included in the measurement of
the liability arising from the transaction.
The entity shall recognised the amount of goods or services received during the vesting based on
the best estimate of the number of awards that are expected to vest.
If subsequent information indicates that the estimate need to be revised, the entity must revise it
and the number of awards must be adjusted accordingly in order to meet the changed
circumstances.

© Emile Woolf International 267 The Institute of Chartered Accountants of Pakistan

Advanced accounting and financial reporting

6 ACCOUNTING FOR SHARE-BASED PAYMENT TRANSACTIONS WITH CASH

ALTERNATIVES
Section overview

 Introduction
 Transactions in which the counterparty has the choice of settlement
 Share-based payment transactions in which the entity has the choice of settlement

6.1 Introduction
Some entities share-based payment arrangements give the counterparties (or the entity) the right
to choose to receive (or pay) cash instead of shares or options, or instead of exercising options.
The standard contains different accounting methods for cash-settled and equity-settled share-
based payment transactions. Where there is a choice of settlement, it is necessary to determine
which accounting method should be applied.
This depends on whether:
 the counterparty has the choice of settlement; or
 the entity has the choice of settlement.

6.2 Transactions in which the counterparty has the choice of settlement

Background
The entity by granting the counterparty a right to choose the settle of share based payment
transaction either in cash or issuing equity instruments has in fact granted compound financial
instrument , (i.e. a financial instrument that includes both debt and equity components). Thus the
counterparty has:
 the right to be paid in cash; with,
 an option to take shares.
The entity must measure the fair value of the compound financial instrument at grant date
identifying a value to both components.
The goods or services received or acquired in respect of each component of the compound
financial instrument are accounted for separately.
 For the debt component, the goods or services acquired, and a liability to pay for those
goods or services are recognised as they are supplied in the same way as other cash-settled
share-based payment transactions.
 For the equity component (if any) the goods or services received and an increase in equity
are recognised as they are supplied in the same way as other equity-settled share-based
payment transactions.
Transactions where the fair value of goods and services is measured directly
This category will not include transactions with employees.
The equity component is measured as the difference between the fair value of the goods or
services received and the fair value of the debt component, at the date when the goods or services
are received. In other words, the equity component is the residual amount.
The liability and equity component are measured at the date the goods and services are received
for transactions where the direct method applies. Therefore, there is no subsequent
remeasurement of the equity component (as no further goods and services are received).
However, the liability component is remeasured as it is usually linked to a share value which will
change over time.

© Emile Woolf International 268 The Institute of Chartered Accountants of Pakistan

 Chapter 12: IFRS 2: Share-based payments

Date of settlement
The liability is remeasured at its fair value at the date of settlement.
 If the entity issues equity instruments on settlement (instead of paying cash), the liability is
transferred direct to equity, as the consideration for the equity instruments issued.
 If the entity pays cash on settlement (instead of issuing equity instruments), any equity
component previously recognised remains in equity. (The entity is allowed to recognise a
transfer within equity, i.e. a transfer from one component of equity to another).

Example: Counter party has choice of settlement (direct measurement)

X Limited is a company with a 31 December year end.
1 January Year 1
X Limited acquired a machine with a fair value of Rs. 500,000.
The contract for the purchase of the machine allows the supplier to choose whether to receive as
payment 30,000 ordinary shares or cash equivalent to the value of 40,000 ordinary shares. In
either case, the payment would be made on 31 December Year 1.
The fair values of the shares at various dates were as follows:

1 January Rs. 12 per share

30 June Rs. 15 per share
31 December Rs. 13 per share
The transaction would be accounted for as follows:
1 January Year 1
Dr Cr
Machine 500,000
Liability (40,000 shares  Rs. 12) 480,000
Equity (balance) 20,000
30 June Year 1
Statement of profit or loss 120,000
Liability:
(40,000 shares  Rs. 15)  Rs. 480,000 120,000
31 December
Liability:
(40,000 shares  Rs. 13)  Rs. 600,000 80,000
Statement of profit or loss 80,000
31 December – payment if settled in cash
Liability 520.000
Cash 520,000
31 December – payment if settled in equity
Liability 520.000
Equity 520,000

© Emile Woolf International 269 The Institute of Chartered Accountants of Pakistan

Advanced accounting and financial reporting

Transactions using indirect measurement

This category includes transactions with employees.
The debt component and the equity component are measured separately. The fair value of the
compound financial instrument is the sum of the fair values of the two components.
Share-based payment transactions in which the counterparty has the choice of settlement are often
structured so that the fair value of one settlement alternative is the same as the other. (For
example, the counterparty might have the choice of receiving share options or cash-settled share
appreciation rights).
In such cases, the fair value of the equity component is zero, and hence the fair value of the
compound financial instrument is the same as the fair value of the debt component. (This is
because the fair value of the equity component must take into account the fact that the holder
forfeits the right to receive cash in order to exercise the option).

Example: Counter party has choice of settlement (indirect measurement)

X Limited is a company with a 31 December year end.
1 January Year 1
X Limited grants share based compensation to each of its 600 employees.
Each employee has an option to select either 200 shares or the cash equivalent to the value of 200
shares on condition that they remain in service for 3 years.
The fair values of the components of the compound instrument were as follows:
Rs.
Equity 3
Liability 15
Compound instrument 18

31 December Year 1
The fair value of the liability component is estimated at Rs. 20.
X Limited expects 75% of its employees will qualify to receive the compensation.

Year 1 expense re liability Rs.

Liability b/f 
Year 1 expense (balancing figure) 600,000
Liability c/f:
(75%  600) employees  200 shares  Rs. 20  1/3 600,000

Year 1 expense re equity

Equity balance b/f 
Year 1 expense (balancing figure) 90,000
Equity balance c/f:
(75%  600) employees  200 shares  Rs. 3  1/3 90,000

Dr Cr
Statement of profit or loss 690,000
Liability 600,000
Equity 90,000

© Emile Woolf International 270 The Institute of Chartered Accountants of Pakistan

 Chapter 12: IFRS 2: Share-based payments

Example: (continued)

31 December Year 2
The fair value of the liability component is estimated at Rs. 25.
X Limited expects 80% of its employees will qualify to receive the compensation

Year 2 expense re liability Rs.

Liability b/f 600,000
Year 2 expense (balancing figure) 1,000,000
Liability c/f:
(80%  600) employees  200 shares  Rs. 25  2/3 1,600,000

Year 2 expense re equity

Equity balance b/f 90,000
Year 2 expense (balancing figure) 102,000
Equity balance c/f:
(80%  600) employees  200 shares  Rs. 3  2/3 192,000

Dr Cr
Statement of profit or loss 1,102,000
Liability 1,000,000
Equity 102,000

31 December Year 3
The fair value of the liability component is estimated at Rs. 30.
500 employees meet the vesting condition.

Year 3 expense re liability Rs.

Liability b/f 1,600,000
Year 3 expense (balancing figure) 1,400,000
Liability c/f:
500 employees  200 shares  Rs. 30  3/3 3,000,000

Year 3 expense re equity

Equity balance b/f 192,000
Year 3 expense (balancing figure) 108,000
Equity balance c/f:
500 employees  200 shares  Rs. 3  3/3 300,000

Dr Cr
Statement of profit or loss 1,508,000
Liability 1,400,000
Equity 108,000

© Emile Woolf International 271 The Institute of Chartered Accountants of Pakistan

Advanced accounting and financial reporting

Example: (continued)
Settlement
31 December – payment if settled in cash
Dr Cr
Liability 3,000,000
Cash 3,000,000
31 December – payment if settled in equity
Dr Cr
Liability 3,000,000
Equity 3,000,000

6.3 Share-based payment transactions in which the entity has the choice of settlement
Where an obligation exists
The entity must determine whether it has a present obligation to settle in cash and account for the
share-based payment transaction accordingly.
The entity has a present obligation to settle in cash if the choice of settlement in equity instruments
 has no commercial substance; or,
 if the entity has a past practice or a stated policy of settling in cash.
Where an obligation exists, the entity must account for the transaction according to the rules
applied to cash-settled share-based payment transactions.
Where there is no obligation
Where an obligation does not exist the entity must account for the transaction according to the
rules applied to equity-settled transactions.
In this case the entity may still decide to settle in cash at the settlement date.
 If the entity elects to settle in cash, the cash payment is accounted for as the repurchase of
an equity interest, i.e. as a deduction from equity.
 if the entity elects to settle by issuing equity instruments, no further accounting is required
(other than a transfer from one component of equity to another, if necessary).
There is a special rule to amend the above where the entity elects the settlement alternative with
the higher fair value, as at the date of settlement. If this is the case the entity must recognise an
additional expense for the excess value given:
 If cash paid is greater than the fair value of the shares that could have otherwise been issued
in settlement, the difference must be taken to profit or loss as expense.
 If shares are issued in settlement and they have a fair value greater than that of the cash
alternative the difference must be taken to profit or loss as expense.

Example: Entity has choice of settlement (indirect measurement)

X Limited is a company with a 31 December year end.
1 January Year 1
X Limited grants share based compensation to each of its 1,200 employees. X Limited will pay 200
shares or the cash equivalent to the value of 200 shares to any employee who satisfies the 3 year
service condition.
The fair value of the share at the grant date is Rs. 18.

© Emile Woolf International 272 The Institute of Chartered Accountants of Pakistan

 Chapter 12: IFRS 2: Share-based payments

The fair values of the shares and the employees whose interest is expected to vest at each reporting
date are as follows:

Date Expected shares to be vested Fair value of equity instrument

Year 1 80% Rs. 17

Year 2 90% Rs. 16

Year 3 1000 Employees Rs. 15

31 December Year 1

Year 1 expense re liability Rs.

Liability b/f 
Year 1 expense (balancing figure) 1,088,000

Liability c/f:
(80%  1,200) employees  200 shares  Rs. 17  1/3 1,088,000

31 December Year 2

Year 2 expense re liability Rs.

Liability b/f 1,088,000

Year 2 expense (balancing figure) 1,216,000

Liability c/f:
(90%  1,200) employees  200 shares  Rs. 16  2/3 2,304,000

31 December Year 3

Year 3 expense re liability Rs.

Liability b/f 2,304,000

Year 3 expense (balancing figure) 696,000

Liability c/f:
1,000 employees  200 shares  Rs. 15  3/3 3,000,000

31 December – payment if actually settled in cash

Dr Cr

Liability 3,000,000

Cash 3,000,000

31 December – payment if settled in equity

Dr Cr

Liability 3,000,000

Equity 3,000,000

© Emile Woolf International 273 The Institute of Chartered Accountants of Pakistan

Advanced accounting and financial reporting

Example: (continued)

Treating the grant as equity-settled

31 December Year 1

Year 1 expense re liability Rs.

Equity balance b/f nil

Year 1 expense (balancing figure) 1,152,000

Equity balance c/f:

(80%  1,200) employees  200 shares  Rs. 18  1/3 1,152,000

31 December Year 2

Year 2 expense re liability Rs.

Equity balance b/f 1,152,000

Year 2 expense (balancing figure) 1,440,000

Equity balance c/f:

(90%  1,200) employees  200 shares  Rs. 18  2/3 2,592,000

31 December Year 3

Year 3 expense re liability Rs.

Equity balance b/f 2,592,000

Year 3 expense (balancing figure) 1,008,000

Equity balance c/f:

1,000 employees  200 shares  Rs. 18  3/3 3,600,000

31 December – payment if actually settled in equity

Dr Cr

Equity 3,600,000

Equity (share capital and share premium) 3,600,000

31 December – payment if settled in cash

Dr Cr

Equity 3,600,000

Retained earnings 600,000

Cash 3,000,000

© Emile Woolf International 274 The Institute of Chartered Accountants of Pakistan

 Chapter 12: IFRS 2: Share-based payments

7 DISCLOSURES

Section overview

 Disclosures about nature and extent of share based payment arrangements

 Disclosures about fair value measurement
 Disclosures about effect on profit or loss for the period and financial position

7.1 Disclosures about nature and extent of share based payment arrangements
Underlying principle
An entity must disclose information that enables users of the financial statements to understand
the nature and extent of share-based payment arrangements that existed during the period.
To give effect to this principle an entity must disclose at least the following:
 a description of each type of share-based payment arrangement that existed at any time
during the period, including the general terms and conditions of each arrangement, such as:
 vesting requirements;
 the maximum term of options granted; and,
 the method of settlement (e.g. whether in cash or equity).
 the number and weighted average exercise prices of share options for each of the following
groups of options:
 outstanding at the beginning of the period;
 granted during the period;
 forfeited during the period;
 exercised during the period;
 expired during the period;
 outstanding at the end of the period; and
 exercisable at the end of the period.
 for share options exercised during the period, the weighted average share price at the date
of exercise. If options were exercised on a regular basis throughout the period, the entity
may instead disclose the weighted average share price during the period.
 for share options outstanding at the end of the period, the range of exercise prices and
weighted average remaining contractual life. If the range of exercise prices is wide, the
outstanding options shall be divided into ranges that are meaningful for assessing the
number and timing of additional shares that may be issued and the cash that may be
received upon exercise of those options.

7.2 Disclosures about fair value measurement

An entity must disclose information to enable users to understand how the fair value of
the goods or services received, or the fair value of the equity instruments granted, during
the period was determined.

© Emile Woolf International 275 The Institute of Chartered Accountants of Pakistan

Advanced accounting and financial reporting

7.3 Disclosures about effect on profit or loss for the period and financial position
Underlying principle
An entity must disclose information that enables users of the financial statements to understand
the effect of share-based payment transactions on the entity’s profit or loss for the period and on
its financial position.
To give effect to this principle an entity must disclose at least the following:
 the total expense recognised for the period arising from share-based payment transactions
in which the goods or services received did not qualify for recognition as assets and hence
were recognised immediately as an expense, including separate disclosure of that portion
of the total expense that arises from transactions accounted for as equity-settled share-
based payment transactions;
 for liabilities arising from share-based payment transactions:
 the total carrying amount at the end of the period; and
 the total intrinsic value at the end of the period of liabilities for which the counterparty’s
right to cash or other assets had vested by the end of the period (e.g. vested share
appreciation rights).

© Emile Woolf International 276 The Institute of Chartered Accountants of Pakistan

 Chapter 12: IFRS 2: Share-based payments

SOLUTIONS TO PRACTICE QUESTIONS

Solutions 1
31 December Year 1
Rs. Equity
Expected outcome (at grant date value)
500 × 85% × 100 × Rs.15 637,500
×1/3
Year 1 charge 212,500
Accumulated in equity 212,500
31 December Year 2
Rs.
Expected outcome (at grant date value)
500 × 88% × 100 × Rs.15 660,000
×2/3
440,000
Less expense previously recognised (212,500)
Year 2 charge 227,500
Accumulated in equity 440,000
31 December Year 3
Rs.
Actual outcome (at grant date value)
44,300 × Rs.15 664,500
Less expense previously recognised (440,000)
Year 3 charge 224,500
Accumulated in equity 664,500

© Emile Woolf International 277 The Institute of Chartered Accountants of Pakistan

Advanced accounting and financial reporting

© Emile Woolf International 278 The Institute of Chartered Accountants of Pakistan

 Certified Finance and Accounting Professional

13

CHAPTER
Advanced accounting and financial reporting

Disposal of subsidiaries

Contents
1 Full disposals
2 Part disposals
3 Disposal of a subsidiary which does not contain a business
4 IFRS 5 and disposals

© Emile Woolf International 279 The Institute of Chartered Accountants of Pakistan

Advanced accounting and financial reporting

1 FULL DISPOSALS

Section overview

 Introduction
 Pattern of ownership
 Profit or loss on disposal
 Step by step approach

1.1 Introduction
A parent company might dispose of a holding in a subsidiary.
IFRS 10 Consolidated Financial Statements contains rules on accounting for disposals of a
subsidiary.
Accounting for a disposal is an issue that impacts the statement of profit or loss.
There are two major tasks in constructing a statement of profit or loss for a period during which
there has been a disposal of a subsidiary:
 The statement of profit or loss must reflect the pattern of ownership of subsidiaries in the
period.
 When control is lost, the statement of profit or loss must show the profit or loss on disposal
of the subsidiary.
The rules in IFRS 10 cover full disposals and part disposals.
When a parent makes a part disposal of an interest in a subsidiary it will be left with a residual
investment. The accounting treatment for a part disposal depends on the nature of the residual
investment.
If a part disposal results in loss of control the parent must recognise a profit or loss on disposal in
the consolidated statement of profit or loss.
A part disposal which does not result in loss of control is a transaction between the owners of the
subsidiary. In this case the parent does not recognise a profit or loss on disposal in the consolidated
statement of profit or loss. Instead the parent recognises an equity adjustment.
1.2 Pattern of ownership
The pattern of ownership in a period is always reflected in the consolidated statement of profit or
loss.
IFRS 11 requires that an interest in a subsidiary is consolidated from the date of acquisition to the
date of disposal.

Illustration: Disposal during the year

© Emile Woolf International 280 The Institute of Chartered Accountants of Pakistan

 Chapter 13: Disposal of subsidiaries

An interest in an associate must also be equity accounted from the date that significant influence
is achieved to the date that it is lost.
Thus, the figures from the statement of profit or loss and other comprehensive income that relate
to the period up to the date of disposal must be identified. In practice, this would normally be
achieved by constructing a set of accounts up to the date of disposal. In exam questions we tend
to use time apportionment.
There is another reason for consolidating up to the date of disposal. The calculation of the profit
on disposal involves comparing the sale proceeds to what leaves the statement of financial positon
as at the date of disposal. Therefore, the results of the subsidiary must be consolidated up to the
date of disposal in order to establish the correct net assets figure.
1.3 Profit or loss on disposal
IFRS 10 specifies an approach to calculating the profit or loss on disposal.
This approach involves comparing the asset that is recognised as a result of the disposal (i.e. the
proceeds of the sale) to the amounts that are derecognised as a result of the disposal.
The calculation is as follows:
Illustration: Profit (loss) on disposal
Recognise: Rs.
Proceeds X
Fair value of residual interest (only for part disposals) X
X
Derecognise:
Net assets of subsidiary X
Non-controlling interest (X)
Share of net assets (X)
Unimpaired goodwill (X)
Profit/(loss) on disposal recognised in profit or loss X

Example: Profit on disposal of a subsidiary

On 1 January Year 9, H Ltd acquired 90% of the equity shares of S Ltd for Rs.120 million.
The fair value of the identifiable net assets in S Ltd at that date was Rs.111 million. The fair value
of the NCI at 1 January Year 9 was Rs.9 million.
H Ltd uses the full goodwill method for consolidation leading to the recognition of goodwill of
Rs.18m ((Rs.120m + Rs.9m  Rs.111m).
H Ltd subsequently sold the shares on 31 December Year 9 for Rs.197 million. The carrying value
of the net assets of S Ltd at 31 December Year 9 was Rs.124 million.
The gain on disposal recognised in profit or loss should be calculated as follows:
Rs. m
Consideration received for shares in S Ltd on 31 December 197.0
Net assets de-recognised in consolidated accounts
Net assets de-recognised 124.0
Value of NCI at 31 December
(Rs. 9m + 10%  (124 million – 111 million)) (10.3)
113.7
Goodwill derecognised: (120 + 9 – 111) 18.0
Net assets sold (131.7)
Gain on disposal, reported in profit or loss 65.3

© Emile Woolf International 281 The Institute of Chartered Accountants of Pakistan

Advanced accounting and financial reporting

The calculation of profit or loss on disposal must be supported by several other calculations. These
are:
 the goodwill arising on acquisition, which in turn needs the net assets of the subsidiary at
the date of acquisition; and
 the net assets of the subsidiary at the date of disposal, which in turn needs a calculation of
the equity reserves at the date of disposal.

Example:
At 1 January Year 9, H Ltd held 80% of the equity of S Ltd. The carrying value of the net assets of
S Ltd at this date was Rs.570 million.
There was also goodwill of Rs.20 million net of accumulated impairments relating to the
investment in S Ltd: all this goodwill is attributable to the equity owners of H Ltd.
On 1 April Year 9, H Ltd sold its entire shareholding in S Ltd for Rs.575 million in cash.
H Ltd has a financial year ending 31 December. It was subsequently established that the profit
after tax of S Ltd for the year to 31 December Year 9 was Rs.120 million.
S Ltd did not make any dividend payment during the year before the disposal of the shares.
How should the disposal of the shares be accounted for? (Ignore deferred taxation).

Answer
In the three months of the year to the date of disposal of the shares in S Ltd, the after-tax profit of
S Ltd was Rs.30 million (Rs.120 million  3/12).
The carrying value of the net assets of S Ltd at the date that control was lost is therefore Rs.600
million (Rs.570 million + Rs.30 million).
The gain on disposal of the shares is as follows:
Rs. million
Consideration received from sale of shares 575
Net assets derecognised (including goodwill) 620
NCI removed/derecognised (120)
H Ltd’s share of assets derecognised (500)
Total gain 75

Practice question 1
P bought 80% of the issued ordinary shares of S, 25 years ago at a cost of Rs. 330,000 when
the net assets of S amounted to Rs. 280,000.
No goodwill is attributed to the non-controlling interests. Goodwill arising on the acquisition
has suffered an impairment of 80% of its original value.
On the final day of the current accounting period P sold its entire shareholding in S for
proceeds of Rs.460,000. At this date the net assets of
S amounted to Rs. 400,000.
Required
What is the profit or loss on disposal reported in consolidated profit or loss for the current
period?

© Emile Woolf International 282 The Institute of Chartered Accountants of Pakistan

 Chapter 13: Disposal of subsidiaries

1.4 Step by step approach

The following approach can be used to prepare answers to questions requiring a consolidated
statement of profit or loss when there is a disposal of a subsidiary during the year.
Step 1: Reflect the pattern of ownership
Construct a pro-forma answer with columns for the parent, the subsidiary and the consolidated
figures.
Enter the figures to be consolidated remembering to prorate the subsidiary’s figures up to the date
of disposal and add across to give the consolidated figures.
The non-controlling interest can be calculated from the subsidiary’s column.
Step 2: Construct the following workings:
 Net assets summary as at the date of disposal and the date of acquisition
 Retained earnings as at the date of disposal (for the above);
 Goodwill arising on acquisition (using the net assets at the date of acquisition from the net
assets summary)
Step 3: Calculate the profit or loss on disposal
Step 4: Include the profit or loss on disposal into the consolidated statement of profit or loss and
finish it off.
Work through the following example carefully.
Example: Facts

Example: Disposal of subsidiary

The following financial statements are to the year-end 31 December 20X4

H S
Statements of profit or loss Rs.000 Rs.000
Revenue 22,950 8,800
Expenses (10,000) (5,000)
Operating profit 12,950 3,800
Tax (5,400 (2,150)
Profit after tax 7,550 1,650

Statement of changes in equity Rs.000 Rs.000

Retained earnings b/f 3,760 1,850
Profit after tax 7,550 1,650
Retained earnings c/f 11,310 3,500

a. H Ltd bought 90% of S Ltd 4 years ago for Rs. 3,750,000 when the retained
earnings of S ltd were Rs. 500,000.
S Ltd has share capital of Rs. 3,000,000.

b. H Ltd sold its entire holding in S Ltd on 30 September 20X4 for Rs. 9,500,000.

c. S Ltd does not qualify to be treated as a discontinued operation under IFRS5.

Prepare the consolidated statement of profit or loss for the year ended 31 December 20X4.

© Emile Woolf International 283 The Institute of Chartered Accountants of Pakistan

Advanced accounting and financial reporting

Step 1: Reflect the pattern of ownership

Answer

H S (9/12) Group
Statements of profit or loss Rs.000 Rs.000 Rs.000
Revenue 22,950 6,600 29,550
Expenses (10,000) (3,750) (13,750)

Operating profit 12,950 2,850 15,800

Profit on disposal (W)
Profit before tax
Tax (5,400) (1,612) (7,012)

Profit after tax 7,550 1,238

Profit attributable to: Rs.000

Owners of the parent
Non-controlling interest (10% of 1,238) 124

Profit for the year

Step 2: Key workings

Answer
W1: Net assets summary
At date of At date of
disposal acquisition
Rs.000 Rs.000
Share capital 3,000 3,000
Retained earnings (W2) 3,088 500
Net assets 6,088 3,500

W2: Retained earnings at date of disposal Rs.000

Retained earnings at start of year 1,850
Profit for the period up to the date of disposal
(9/12  1,650,000) 1,238
3,088

W3: Goodwill Rs.000

Cost of investment 3,750
Non-controlling interest at acquisition
(10%  3,500,000 (W1)) 350
4,100
Net assets at acquisition (see above) (3,500)
600

© Emile Woolf International 284 The Institute of Chartered Accountants of Pakistan

 Chapter 13: Disposal of subsidiaries

Step 3: Profit on disposal

Answer
W4: Profit on disposal Rs.000
Sale proceeds 9,500
Derecognise:
Net assets at date of disposal (W1) 6,088
NCI at date of disposal (10%  6,088,000 (W1)) (609)
(5,479)
Goodwill (W3) (600)
3,421

Step 4: Complete the answer

Answer
H Plc: Consolidated statement of profit or loss for the year ended 31 December 20X4

H S (9/12) Group
Statements of profit or loss Rs.000 Rs.000 Rs.000
Revenue 22,950 6,600 29,550
Expenses (10,000) (3,750) (13,750)

Operating profit 12,950 2,850 15,800

Profit on disposal (W) 3,421
Profit before tax 19,221
Tax (5,400) (1,612) (7,012)

Profit after tax 7,550 1,238 12,209

Profit attributable to: Rs.000

Owners of the parent (balancing figure) 12,085
Non-controlling interest (10% of 1,238) 124

Profit for the year 12,209

© Emile Woolf International 285 The Institute of Chartered Accountants of Pakistan

Advanced accounting and financial reporting

2 PART DISPOSALS

Section overview

 Part disposal with loss of control

 Part disposal with no loss of control

2.1 Part disposal with loss of control

As stated previously there are two major tasks in constructing a statement of profit or loss for a
period during which there has been a disposal of a subsidiary:
 The statement of profit or loss must reflect the pattern of ownership of subsidiaries in the
period.
 When control is lost, the statement of profit or loss must show the profit or loss on disposal
of the subsidiary.
When a parent makes a part disposal of an interest in a subsidiary it will be left with a residual
investment. The accounting treatment for a part disposal depends on the nature of the residual
investment.
If a part disposal results in loss of control the parent must recognise a profit or loss on disposal in
the consolidated statement of profit or loss.
 The pattern of ownership must reflect the nature of the residual investment.
IFRS calculation of profit on disposal has been shown before but is repeated here for your
convenience.

Illustration: Profit (loss) on disposal

Recognise: Rs.
Proceeds X
Fair value of residual interest (only for part disposals) X
X
Derecognise:
Net assets of subsidiary X
Non-controlling interest (X)
Share of net assets (X)
Unimpaired goodwill (X)
X

Example: Profit on part disposal of a subsidiary

H Ltd acquired 90% of the equity shares of S Ltd for Rs.120 million.
Goodwill on consolidation was Rs.18m
There had been no impairment of goodwill since the date of acquisition.
H Ltd sold a 50% holding (leaving it with a 40% holding) for Rs.100 million. This transaction
resulted in H Ltd losing control of S ltd.
The fair value of the residual investment (i.e. the remaining 40%) was estimated to be Rs.70
The carrying value of the net assets of S Ltd at 31 December Year 9 was Rs.124 million.

© Emile Woolf International 286 The Institute of Chartered Accountants of Pakistan

 Chapter 13: Disposal of subsidiaries

Example: Profit on part disposal of a subsidiary

The gain on disposal recognised in profit or loss should be calculated as follows:
Recognised: Rs. m
Consideration received for shares in S Ltd on 31 December 100.0
Fair value of residual investment 70.0
170.0
Derecognised:
Net assets de-recognised 124.0
NCI (10%  124 million) (12.4)
111.6
Goodwill derecognised 18.0
Net assets sold (129.6)
Gain on disposal, reported in profit or loss 40.4

Practice question 2
Paprika, the holding company of a large group, had bought 90% of the issued capital
Saffron several years ago.
Both companies prepare accounts to 31 December each year.
On 31 October Year 5 Paprika sold 50% of its shareholding in Saffron for Rs. 540,000.
At this date, the carrying value of the net assets of Saffron was Rs. 800,000 and the carrying
value of the goodwill relating to the acquisition of Saffron (all attributable to the parent
company) was Rs. 100,000.
The fair value of the remaining investment in S is estimated at Rs.500,000.
What gain or loss should be recognised on the disposal of the shares in Saffron?

The same step by step approach shown earlier can be used to prepare answers to questions
requiring a consolidated statement of profit or loss when there is a part disposal of a subsidiary
during the year and that part disposal results in a loss of control.
Work through the following example carefully.
Example: Facts
Example: Part disposal (loss of control but leaving significant influence)
The following financial statements are for the year-end 31 December 20X4
H S
Statements of profit or loss Rs.000 Rs.000
Revenue 22,950 8,800
Expenses (10,000) (5,000)
Operating profit 12,950 3,800
Tax (5,400) (2,150)
Profit after tax 7,550 1,650

Statement of changes in equity Rs.000 Rs.000

Retained earnings b/f 3,760 1,850
Profit after tax 7,550 1,650
Retained earnings c/f 11,310 3,500

© Emile Woolf International 287 The Institute of Chartered Accountants of Pakistan

Advanced accounting and financial reporting

Example: (continued)
a. H Ltd bought 90% of S Ltd 4 years ago for Rs. 3,750,000 when the retained earnings
of S ltd were Rs. 500,000.
S Ltd has share capital of Rs. 3,000,000.
b. H Ltd sold 50% of S Ltd on 30 September 20X4 for Rs. 5,000,000.
c. The remaining 40% investment in S Ltd held by H Ltd resulted in H Ltd having
significant influence over S Ltd. This residual investment was estimated to have a
fair value of Rs.3,500,000
d. S Ltd does not qualify to be treated as a discontinued operation under IFRS5.
Required
Prepare the consolidated statement of profit or loss for the year ended 31 December
20X4.
Step 1: Reflect the pattern of ownership

Answer

H S (9/12) Group
Statements of profit or loss Rs.000 Rs.000 Rs.000
Revenue 22,950 6,600 29,550
Expenses (10,000) (3,750) (13,750)

Operating profit 12,950 2,850 15,800

Share of profits of associate
(40%  3/12  1,650) 165
Profit on disposal (W)
Profit before tax
Tax (5,400) (1,612) (7,012)

Profit after tax 7,550 1,238

Profit attributable to: Rs.000

Owners of the parent
Non-controlling interest (10% of 1,238) 124

Profit for the year

Step 2: Key workings

Answer
W1: Net assets summary
At date of At date of
disposal acquisition
Rs.000 Rs.000
Share capital 3,000 3,000
Retained earnings (W2) 3,088 500
Net assets 6,088 3,500

© Emile Woolf International 288 The Institute of Chartered Accountants of Pakistan

 Chapter 13: Disposal of subsidiaries

Example: (continued)
W2: Retained earnings at date of disposal Rs.000
Retained earnings at start of year 1,850
Profit for the period up to the date of disposal
(9/12  1,650,000) 1,238
3,088
W3: Goodwill
Cost of investment 3,750
Non-controlling interest at acquisition
(10%  3,500,000 (W1)) 350
4,100
Net assets at acquisition (see above) (3,500)
600

Step 3: Profit on disposal

Answer
W4: Profit on disposal Rs.000
Recognise
Sale proceeds 5,000
Fair value of residual investment 3,500
8,500
Derecognise:
Net assets at date of disposal (W1) 6,088
NCI at date of disposal (10%  6,088,000 (W1)) (609)
(5,479)
Goodwill (W3) (600)
2,421

Step 4: Complete the answer

Answer
H Plc: Consolidated statement of profit or loss for the year ended 31 December 20X4
H S (9/12) Group
Statements of profit or loss Rs.000 Rs.000 Rs.000
Revenue 22,950 6,600 29,550
Expenses (10,000) (3,750) (13,750)
Operating profit 12,950 2,850 15,800
Share of profits of associate
(40%  3/12  1,650) 165
Profit on disposal (W) 2,421
Profit before tax 18,386
Tax (5,400) (1,612) (7,012)
Profit after tax 7,550 1,238 11,374

Profit attributable to: Rs.000

Owners of the parent (balancing figure) 11,250
Non-controlling interest (10% of 1,238) 124
Profit for the year 11,374

© Emile Woolf International 289 The Institute of Chartered Accountants of Pakistan

Advanced accounting and financial reporting

2.2 Part disposal with no loss of control

A part disposal which does not result in loss of control is a transaction between the owners of the
subsidiary. In this case the parent does not recognise a profit or loss on disposal in the consolidated
statement of profit or loss. Instead the parent recognises an equity adjustment.

Example: Part disposal with no loss of control

The following financial statements are to the year-end 31 December 20X4
H S
Statements of profit or loss Rs.000 Rs.000
Revenue 22,950 8,800
Expenses (10,000) (5,000)
Operating profit 12,950 3,800
Tax (5,400) (2,150)
Profit after tax 7,550 1,650
Statement of changes in equity
Retained earnings b/f 3,760 1,850
Profit after tax 7,550 1,650
Retained earnings c/f 11,310 3,500

a. H Ltd bought 90% of S Ltd 4 years ago for Rs. 3,750,000 when the retained earnings
of S ltd were Rs. 500,000.
S Ltd has share capital of Rs. 3,000,000.

b. H Ltd sold 10% of S Ltd on 30 September 20X4 for Rs. 1,000,000.

Required
Prepare the consolidated statement of profit or loss for the year ended 31 December 20X4
and calculate the equity adjustment necessary to reflect the change in ownership.

Step 1: Reflect the pattern of ownership and complete the statement of profit and loss
This is straightforward as the parent has held a subsidiary for the whole year. The only complication
is that the results have to be time apportioned so that the relevant NCI can be measured.
Profit on disposal is NOT recognised where there is no loss of control.

Answer

H S Group
Statements of profit or loss Rs.000 Rs.000 Rs.000
Revenue 22,950 8,800 31,750
Expenses (10,000) (5,000) (15,000)
Profit before tax 12,950 3,800 16,750
Tax (5,400) (2,150) (7,550)
Profit after tax 7,550 1,650 9,200

© Emile Woolf International 290 The Institute of Chartered Accountants of Pakistan

 Chapter 13: Disposal of subsidiaries

Profit attributable to: Rs.000

Owners of the parent (as a balancing figure) 8,993
Non-controlling interest
(10%  1,650  9/12) 124
(20%  1,650  3/12) 83
207
Profit for the year 9,200

Step 2: Key workings

Answer

W1: Net assets summary

At date of At date of
disposal acquisition
Rs.000 Rs.000
Share capital 3,000 3,000
Retained earnings (W2) 3,088 500
Net assets 6,088 3,500

W2: Retained earnings at date of disposal Rs.000

Retained earnings at start of year 1,850
Profit for the period up to the date of disposal (9/12  1,650,000) 1,238
3,088
W3: Goodwill
Cost of investment 3,750
Non-controlling interest at acquisition (10%  3,500,000 (W1)) 350
4,100
Net assets at acquisition (see above) (3,500)
600

Step 3: Equity adjustment

Answer
W4: Profit on disposal Rs.000

Sale proceeds 1,000

Net assets sold to the NCI (10%  6,088,000 (W1)) (609)
391
The double entry to record the equity adjustment is as follows:
Debit Credit
Cash 1,000
Non-controlling interest 609
Retained earnings 391

© Emile Woolf International 291 The Institute of Chartered Accountants of Pakistan

Advanced accounting and financial reporting

3 DISPOSAL OF A SUBSIDIARY WHICH DOES NOT CONTAIN A BUSINESS

Section overview

 Background
 Requirements

3.1 Background
This section explains a situation where a parent loses control of a subsidiary that does not contain
a business (as defined in IFRS 3) by selling an interest to an associate (or joint venture) accounted
for using the equity method.
Such a transaction is the same as selling an asset to the associate (or joint venture).
Usually, if a parent loses control of a subsidiary, the parent must:
 derecognise the assets and liabilities of the former subsidiary from the consolidated
statement of financial position.
 recognise any investment retained in the former subsidiary at its fair value when control is
lost; and
 recognise the gain or loss associated with the loss of control in the statement of profit or
loss.
In the case of a part disposal, the parent must measure any residual investment at its fair value
with any gain or loss being recognised in the statement of profit or loss.

3.2 Requirements
If the subsidiary sold does not contain a business (as defined in IFRS 3) by selling an interest to
an associate (or joint venture) accounted for using the equity method the gain or loss resulting from
the transaction is recognised in the parent’s profit or loss only to the extent of the unrelated
investors’ interests in that associate or joint venture.
The remaining part of the gain is eliminated against the carrying amount of the investment in that
associate or joint venture.
Also any residual investment that is being accounted for according to IFRS 9 must be revalued to
fair value and usually the gain or loss is recognised in profit or loss.
The residual investment might be an associate (or joint venture) accounted for using the equity
method. In that case the remeasurement gain or loss is recognised in profit or loss only to the
extent of the unrelated investors’ interests in the new associate or joint venture.
The remaining part of that gain is eliminated against the carrying amount of the investment retained
in the former subsidiary.

© Emile Woolf International 292 The Institute of Chartered Accountants of Pakistan

 Chapter 13: Disposal of subsidiaries

Example: Loss of control of a subsidiary (that does not contain a business) by selling it to an
associate
H Ltd owns 100% of S Ltd (a company which does not contain a business).
H Ltd owns 20% of A Ltd.
H Ltd sold 70% of S Ltd to A Ltd for Rs.210 million.
The fair value of the identifiable net assets in S Ltd at the date of the sale was Rs.100 million.
The fair value of the residual investment at the date of disposal was Rs.90 million.

The gain on disposal recognised in profit or loss should be calculated as follows:

Rs. m
Consideration received for shares in S Ltd 210.0
Fair value of the residual interest 90.0
300.0
Net assets de-recognised (100.0)
Gain on disposal 200.0
H Ltd recognises the gain to the extent of the unrelated investors’ interests.
H Ltd ’s interests and those of unrelated investors after the disposal are as follows:
Interests in A Ltd:
H Ltd 20%
Unrelated investors 80%
Total 100%

Interests in S Ltd:
H Ltd
Direct interest 30%
Indirect interest (20% of 70%) 14%
44%
Unrelated investors (80% of 70%) 56%
Total 100%
The gain must be analysed into that part which relates to the actual sale and that part which
relates to the revaluation of the residual investment.
Total Sale Revaluation
Rs. m Rs. m Rs. m
Consideration received 210.0 210.0 90.0
Fair value of the residual interest 90.0
300.0
Net assets de-recognised (100.0) (70.0) (30.0)
Gain on disposal 200.0 140.0 60.0
The gain must be analysed into that part which relates to the actual sale and that part which
relates to the revaluation of the residual investment.

© Emile Woolf International 293 The Institute of Chartered Accountants of Pakistan

Advanced accounting and financial reporting

The recognition of the gain is based on the ownership interests as follows:

Sale Revaluation
Rs. m Rs. m
Gain on disposal 140.0 60.0

Interests in A Ltd:
H Ltd (20%) 28.0
Unrelated investors (80%) 112.0

Interests in S Ltd:
H Ltd (44%) 26.0
Unrelated investors (56%) 34.0

The double entry to account for the disposal may be summarised as:
Dr (Rs. m) Cr (Rs. m)
Cash 210.0
Net assets 100.0
Investment in S (90  26) 64.0
Investment in A 28.0
Gain on disposal (reported in profit or loss)
(112.0 + 34.0) 146.0
274.0 274.0

© Emile Woolf International 294 The Institute of Chartered Accountants of Pakistan

 Chapter 13: Disposal of subsidiaries

4 IFRS 5 AND DISPOSALS

Section overview

 IFRS 5: Non-current Assets Held for Sale and Discontinued operations

 Presentation of discontinued operations
 Discontinued operations and disposals

4.1 IFRS 5: Non-current Assets Held for Sale and Discontinued operations
This was covered in an earlier chapter but is repeated here for your convenience. It sets out
requirements for disclosure of financial information relating to discontinued operations.
A discontinued operation is a disposal group that satisfies extra criteria. (IFRS 5 does not say as
much but this is a helpful way to think of it).

Definition
Discontinued operation - A component of an entity that either has been disposed of or is
classified as held for sale and:
1. represents a separate major line of business or geographical area of operations,
2. is part of a single co-ordinated plan to dispose of a separate major line of business or
geographical area of operations or
3. is a subsidiary acquired exclusively with a view to resale.

A component of an entity comprises operations and cash flows that can be clearly distinguished,
operationally and for financial reporting purposes, from the rest of the entity.
A disposal group might be, for example, a major business division of a company.

4.2 Presentation of discontinued operations

Presentation in the statement of profit or loss
The following must be disclosed for discontinued operations:
 a single amount on the face of the statement of profit or loss comprising the total of:
 the post-tax profit or loss of discontinued operations; and
 the post-tax gain or loss recognised on the measurement to fair value less costs to
sell or on the disposal of the assets or disposal group(s) constituting the discontinued
operation.
4.3 Discontinued operations and disposals
A disposal might satisfy the discontinued operations criteria.
This will not affect measurement but will affect presentation.
The consolidation of the subsidiary up to the date of disposal is not carried out on a line by line
basis. Instead, the profit after tax for this period combined with the profit (loss) on disposal and
shown as a single figure.

© Emile Woolf International 295 The Institute of Chartered Accountants of Pakistan

Advanced accounting and financial reporting

The answer to the previous example is used below to show the difference.

Example: Disposal of subsidiary – Not a discontinued operation (as seen before)

H Ltd: Consolidated statement of profit or loss for the year ended 31 December 20X4

H S (9/12) Group
Statements of profit or loss Rs.000 Rs.000
Revenue 22,950 6,600 29,550
Expenses (10,000) (3,750) (13,750)

Operating profit 12,950 2,850 15,800

Profit on disposal (W) 3,421
Profit before tax 19,221
Tax (5,400) (1,612) (7,012)

Profit after tax 7,550 1,238 12,209

Profit attributable to: Rs.000

Owners of the parent (balancing figure) 12,085
Non-controlling interest (10% of 1,238) 124

Profit for the year 12,209

Group
Statements of profit or loss Rs.000
Revenue 22,950
Expenses (10,000)

Profit before tax 12,950

Tax (5,400)

Profit for the period from continuing operations 7,550

Profit for the year from discontinued operations

(1,238 + 3,421) 4,659
Profit for the year 12,209

Profit attributable to: Rs.000

Owners of the parent (balancing figure) 12,085
Non-controlling interest (10% of 1,238) 124

Profit for the year 12,209

© Emile Woolf International 296 The Institute of Chartered Accountants of Pakistan

 Chapter 13: Disposal of subsidiaries

SOLUTIONS TO PRACTICE QUESTIONS

Solution 1
Rs.
Proceeds received 460,000

Net assets disposed of at carrying value 400,000

Attributable to non-controlling interests (20%) (80,000)
320,000
Unimpaired goodwill attributable to P 21,200

Gain to equity owners of P on disposal of S 341,200

Gain on disposal, reported in profit or loss 118,800

Goodwill on the acquisition attributable to P:

= Rs.330,000 - (80%  Rs.280,000) = Rs.106,000
Goodwill remaining after accumulated impairment (20%  Rs.106,000) = Rs.21,200.

Solution 2
Rs.
Proceeds received from sale of shares 540,000
Fair value of remaining investment in S 500,000
1,040,000

Net assets disposed of at carrying value 800,000

Attributable to non-controlling interests (20%) (80,000)
720,000
Unimpaired goodwill attributable to P 100,000

Gain to equity owners of P on disposal of S (820,000)

Gain on disposal, reported in profit or loss 220,000

© Emile Woolf International 297 The Institute of Chartered Accountants of Pakistan

Advanced accounting and financial reporting

© Emile Woolf International 298 The Institute of Chartered Accountants of Pakistan

 Certified Finance and Accounting Professional

14

CHAPTER
Advanced accounting and financial reporting

IFRS 5: Non-current assets held for sale

and discontinued operations

Contents
1 Sale of non-current assets
2 Objective and Scope
3 Classification of non-current assets (or disposal groups) as
held for sale
4 Measurement of non-current assets (or disposal groups)
classified as held for sale
5 Presentation and disclosure
6 Discontinued operations

© Emile Woolf International 299 The Institute of Chartered Accountants of Pakistan

Advanced accounting and financial reporting

1 SALE OF NON-CURRENT ASSETS

Section overview

 General rules on derecognition

 Assets that are held for sale

1.1 General rules on derecognition

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

1.2 Assets that are held for sale

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

© Emile Woolf International 300 The Institute of Chartered Accountants of Pakistan

 Chapter 14: IFRS 5: Non-current assets held for sale and discontinued operations

2 OBJECTVE AND SCOPE

Section overview

 Objective
 Scope

2.1 Objective
IFRS 5 sets out requirements that specify the accounting treatment for assets held for sale, and
the presentation and disclosure of discontinued operations.
IFRS 5 requires assets that meet the criteria to be classified as held for sale are:
 measured at the lower of carrying amount and fair value less costs to sell;
 not depreciated; and
 presented separately on the face of the statement of financial position.
Additionally, the results of discontinued operations must be presented separately in the statement
of profit or loss.
IFRS 5 identifies three classes of item that might be described as held for sale. These classes are
of an increasing level of sophistication:
 non-current assets;
 disposal groups; and
 discontinued operations.
Disposal group

Definition
Disposal group – a group of assets to be disposed of in a single transaction, and any liabilities
directly associated with those assets that will be transferred in the transaction.

A disposal group may be a group of cash-generating units, a single cash-generating unit, or part
of a cash-generating unit.
Some disposal groups might fall into the definition of a discontinued operation.
2.2 Scope
Classification and presentation
The classification and presentation requirements of IFRS 5 apply to all recognised non-current
assets and to all disposal groups.
Measurement
The measurement requirements of IFRS 5 apply to all recognised non-current assets and disposal
groups except for:
 deferred tax assets (IAS 12 Income Taxes).
 assets arising from employee benefits (IAS 19 Employee Benefits).
 financial assets within the scope of IFRS 09 Financial Instruments.
 non-current assets that are accounted for in accordance with the fair value model in IAS 40
Investment Property.
 non-current assets that are measured at fair value less estimated point-of-sale costs in
accordance with IAS 41 Agriculture.
 contractual rights under insurance contracts as defined in IFRS 4 Insurance Contracts.

© Emile Woolf International 301 The Institute of Chartered Accountants of Pakistan

Advanced accounting and financial reporting

Comment on the scope of IFRS 5

The scope of IFRS 5 is a little complicated.
A non-current asset that is scoped out of IFRS 5 for measurement purposes may fall within the
classification and presentation rules.
Such a non-current asset might be part of a disposal group. In this case the measurement rules of
IFRS 5 apply to the disposal group as a whole but not to the scoped out assets within the group
which are measured individually according to the rules set out in their own standards.
Abandonment of non-current assets
Non-current assets (or disposal groups) to be abandoned include non-current assets (or disposal
groups) that are to be:
 used to the end of their economic life; or
 closed rather than sold.
A non-current asset (or disposal group) that is to be abandoned must not be classified as held for
sale in accordance with IFRS 5.
Reclassification of non-current assets
Assets classified as non-current in accordance with IAS 1: Presentation of financial statements
cannot be reclassified as current assets until they meet the criteria to be classified as held for sale.
This also applies to assets that would normally be regarded as non-current that are acquired
exclusively with a view to resale. Such assets cannot be classified as current unless they meet the
criteria to be classified as held for sale in accordance with IFRS 5.

© Emile Woolf International 302 The Institute of Chartered Accountants of Pakistan

 Chapter 14: IFRS 5: Non-current assets held for sale and discontinued operations

3 CLASSIFICATION OF NON-CURRENT ASSETS (OR DISPOSAL GROUPS) AS

HELD FOR SALE

Section overview

 Criteria
 Sale expected in over 1 year

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

Example: Classification of asset as held for sale

Entity R had the following asset at 31 March Year 4.
A property that it offered for sale for Rs. 5 million during June Year 3.
The market for this type of property has deteriorated and at 31 March Year 4 a buyer had not yet
been found.
Management does not wish to reduce the price because it hopes that the market will improve.
Shortly after the year end (after 31 March Year 4) the entity received an offer of Rs. 4 million and
the property was eventually sold for Rs. 3.5 million during May Year 4, before the financial
statements were authorised for issue.

© Emile Woolf International 303 The Institute of Chartered Accountants of Pakistan

Advanced accounting and financial reporting

Example: Classification of asset as held for sale (continued)

Analysis as at 31 March Year 4
The property cannot be classified as ‘held for sale’.
A non-current asset qualifies as ‘held for sale’ if it is available for immediate sale in its present
condition and actively marketed for sale at a price that is reasonable in relation to its current fair
value.
The property had not been sold at the year-end although it had been on the market for some time.
It appears that the reason for this was that management were asking too high a price; therefore
the price is not reasonable in relation to its current fair value.

Example: Classification of asset as held for sale

Entity R had the following asset at 31 March Year 4.
Plant with a carrying value of Rs. 2.5 million.
At 31 March Year 4 the entity had ceased to use the plant but was still maintaining it in working
condition so that it could still be used if needed.
Entity R sold the plant on 14 May Year 4.
Analysis as at 31 March Year 4

The plant cannot be classified as ‘held for sale’.

At the year-end management had not made a firm commitment to sell the plant. Even though the
plant was sold just after the year-end, IFRS 5 prohibits the classification of non-current assets as
‘held for sale’ if the criteria are met after the end of the reporting period and before the financial
statements are signed.

3.2 Sale expected in over 1 year

Sometimes circumstances might extend the period to complete the sale beyond a year. This does
not preclude an asset (or disposal group) from being classified as held for sale as long as:
 the delay is caused by events or circumstances beyond the entity’s control; and
 there is sufficient evidence that the entity remains committed to its plan to sell the asset (or
disposal group).
IFRS 5 sets out detailed guidance on when this is deemed to be the case.
Costs to sell that are to be paid after one year should be discounted with the unwinding of the
discount recognised subsequently as finance cost in the statement of profit or loss.

© Emile Woolf International 304 The Institute of Chartered Accountants of Pakistan

 Chapter 14: IFRS 5: Non-current assets held for sale and discontinued operations

4 MEASUREMENT OF NON-CURRENT ASSETS (OR DISPOSAL GROUPS)

CLASSIFIED AS HELD FOR SALE

Section overview

 Measurement of non-current assets and disposal groups held for sale

 Allocation of an impairment loss on a disposal group
 Subsequent remeasurement
 Changes to a plan of sale

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

Example: Impact of classification as held for sale

An asset is reclassified as ‘held for sale’, when its carrying amount is Rs. 20 million.
Its fair value less estimated costs to sell is Rs. 17 million.
The asset should be revalued at Rs. 17 million and a loss of Rs. 3 million should be reported in the
period.

If the carrying amount is less than the fair value less costs to sell there is no impairment. In this
case there is no adjustment to the carrying amount of the asset. (A gain is not recognised on
reclassification as held for sale).

Example: Impact of classification as held for sale

An asset is reclassified as ‘held for sale’, when its carrying amount is Rs. 20 million.
Its fair value less estimated costs to sell is Rs. 24 million.
The asset ‘held for sale’ should not be remeasured and should continue to be carried at Rs. 20
million.

A gain on disposal will be included in profit for the period when the disposal actually occurs.

Example: Accounting on reclassification and subsequent disposal

A machine was purchased on 1 January Year 1 for Rs. 80,000. It had a useful life of 8 years and
no residual value.
On 31 December Year 4 the machine was classified as held for sale. On this date the machine’s
fair value was estimated at Rs. 50,000 and the costs to sell were estimated at Rs. 1,000
The machine was sold for Rs. 48,000 on 30 June Year 5.

© Emile Woolf International 305 The Institute of Chartered Accountants of Pakistan

Advanced accounting and financial reporting

Example: Accounting on reclassification and subsequent disposal

This would be accounted for as follows:

Year 4

The asset held for sales is carried at the lower of:

Carrying amount: Rs.

Cost 80,000

Depreciation up to the point of reclassification

80,000  4 years/8years (40,000)

40,000

Fair value less costs to sell (Rs. 50,000  Rs. 1,000) 49,000

The machine therefore remains at its carrying value of Rs. 40,000.

The machine would be reclassified to the held for sale category.
The necessary double entry is as follows:

Debit Credit

Non-current asset held for sale 40,000

Cost (plant) 80,000

Accumulated depreciation 40,000

Year 5

The asset is sold to give the following profit on disposal:

Rs.

Proceeds 48,000

Carrying amount (40,000)

Gain 8,000

The necessary double entry is as follows:

Debit Credit

Cash 48,000

Non-current asset held for sale 40,000

Statement of profit or loss (gain on disposal) 8,000

© Emile Woolf International 306 The Institute of Chartered Accountants of Pakistan

 Chapter 14: IFRS 5: Non-current assets held for sale and discontinued operations

Example: Accounting on reclassification and subsequent disposal

A machine was purchased on 1 January Year 1 for Rs. 80,000. It had a useful life of 8 years and
no residual value.
On 31 December Year 4 the machine was classified as held for sale. On this date the machine’s
fair value was estimated at Rs. 41,000 and the costs to sell were estimated at Rs. 2,000
The machine was sold for Rs. 37,500 on 30 June Year 5.
This would be accounted for as follows:

Year 4

The asset held for sales is carried at the lower of:

Carrying amount: Rs.

Cost 80,000

Depreciation up to the point of reclassification

80,000  4 years/8years (40,000)

40,000

Fair value less costs to sell (Rs. 41,000  Rs. 2,000) 39,000

The machine is therefore written down to Rs. 39,000.

The statement of profit or loss for Year 4 will include an impairment loss of Rs. 1,000 (Rs.
40,000 – Rs. 39,000).
The necessary double entry is as follows:

Debit Credit

Non-current asset held for sale 39,000

Impairment loss 1,000

Cost (plant) 80,000

Accumulated depreciation 40,000

Year 5

The asset is sold to give the following loss on disposal:

Rs.

Proceeds 37,500

Carrying amount (39,000)

Loss 1,500

The necessary double entry is as follows:

Debit Credit

Cash 37,500

Non-current asset held for sale 39,000

Statement of profit or loss (loss on disposal) 1,500

© Emile Woolf International 307 The Institute of Chartered Accountants of Pakistan

Advanced accounting and financial reporting

4.2 Allocation of an impairment loss on a disposal group

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

Example: Allocation of impairment loss in a disposal group

An entity has decided to dispose of a group of its assets.
The carrying amount of the assets immediately before the classification as held to sale were as
follows:

Rs.

Goodwill 20,000

Property, plant and equipment (carried at revalued amounts) 52,000

Property, plant and equipment (carried at cost) 80,000

Inventory 21,000

Financial assets 17,000

Total 190,000

The entity estimates that the ‘fair value less costs to sell’ of the disposal group is Rs. 160,000.
This means that the entity must recognise an impairment loss of Rs. 30,000 (Rs. 190,000 - Rs.
160,000).
Allocation of the impairment loss:
The first Rs. 20,000 of the impairment loss reduces the goodwill to zero.
The remaining Rs. 10,000 of the impairment loss should be allocated to the non-current assets in
the disposal group pro rata to their carrying value.

Carrying
Carrying amount Impairment amount after
before allocation loss allocation

Rs. Rs. Rs.

Goodwill 20,000 20,000 

Property, plant and
equipment (carried at
revalued amounts) 52,000 3,399 48,601

Property, plant and

equipment (carried at cost)
80,000 5,228 74,772

Inventory 21,000 1,373 19,627

Financial assets 17,000  17,000

Total 190,000 30,000 160,000

This impairment loss of Rs. 30,000 will be included in the reported profit or loss from discontinued
operations.

© Emile Woolf International 308 The Institute of Chartered Accountants of Pakistan

 Chapter 14: IFRS 5: Non-current assets held for sale and discontinued operations

4.3 Subsequent remeasurement

Subsequent remeasurement of the non-current asset (or disposal group) might lead to:
 a further impairment loss - which must be recognised; or
 a gain - which is recognised but only to the extent that it is covered by a previously
recognised impairment loss.

4.4 Changes to a plan of sale

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

© Emile Woolf International 309 The Institute of Chartered Accountants of Pakistan

Advanced accounting and financial reporting

5 PRESENTATION AND DISCLOSURE

Section overview

 Assets (or disposal groups) held for sale

5.1 Assets (or disposal groups) held for sale

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

© Emile Woolf International 310 The Institute of Chartered Accountants of Pakistan

 Chapter 14: IFRS 5: Non-current assets held for sale and discontinued operations

6 DISCONTINUED OPERATIONS
Section overview

 Discontinued operation
 Definition of discontinued operations
 Presentation and disclosure of discontinued operations
 Other disclosures

6.1 Discontinued operation

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

6.2 Definition of discontinued operations

A discontinued operation is a disposal group that satisfies extra criteria. (IFRS 5 does not say as
much but this is a helpful way to think of it).

Definition: Discontinued operation

Discontinued operation - A component of an entity that either has been disposed of or is classified
as held for sale and:
1. represents a separate major line of business or geographical area of operations,
2. is part of a single co-ordinated plan to dispose of a separate major line of business or
geographical area of operations or
3. is a subsidiary acquired exclusively with a view to resale.

A component of an entity comprises operations and cash flows that can be clearly distinguished,
operationally and for financial reporting purposes, from the rest of the entity.
If an entity disposes of an individual non-current asset, or plans to dispose of an individual asset
in the immediate future, this is not classified as a discontinued operation unless the asset meets
the definition of a ‘component of an entity’. The asset disposal should simply be accounted for in
the ‘normal’ way, with the gain or loss on disposal included in the operating profit for the year.
An operation cannot be classified as discontinued in the statement of financial position if the criteria
for classifying it as discontinued are met after the end of the reporting period.
For example, suppose that an entity with a financial year ending 30 June shuts down a major line
of business in July and puts another major line of business up for sale. It cannot classify these as
discontinued operations in the financial statements of the year just ended in June, even though the
financial statements for this year have not yet been approved and issued.
A disposal group might be, for example, a major business division of a company.
For example, a company that operates in both shipbuilding and travel and tourism might decide to
put its shipbuilding division up for sale. If the circumstances meet the definition of ‘held for sale’ in
IFRS 5, the shipbuilding division would be a disposal group held for sale.

© Emile Woolf International 311 The Institute of Chartered Accountants of Pakistan

Advanced accounting and financial reporting

6.3 Presentation and disclosure of discontinued operations

Presentation in the statement of comprehensive income
The following must be disclosed for discontinued operations:
 a single amount on the face of the statement of comprehensive income comprising the total
of:
 the post-tax profit or loss of discontinued operations; and
 the post-tax gain or loss recognised on the measurement to fair value less costs to sell
or on the disposal of the assets or disposal group(s) constituting the discontinued
operation.
 an analysis of this single amount:
 the revenue, expenses and pre-tax profit or loss of discontinued operations;
 the related income tax expense;
 the gain or loss recognised on the measurement to fair value less costs to sell or on the
disposal of the assets or disposal group(s) constituting the discontinued operation.
 the net cash flows attributable to the operating, investing and financing activities of
discontinued operations.
 the analysis may be presented in the notes or on the face of the statement of comprehensive
income. (If presented on the face of the statement of profit or loss it must be presented in a
section identified as relating to discontinued operations).
 the amount of income from continuing operations and from discontinued operations
attributable to owners of the parent. These disclosures may be presented either in the notes
or in the statement of comprehensive income.
The analysis is not required for disposal groups that are newly acquired subsidiaries that are
classified as held for sale on acquisition.
These disclosures are not required for disposal groups that are newly acquired subsidiaries that
are classified as held for sale on acquisition.
Presentation in the statement of financial position
Non-current assets classified as held for sale must be disclosed separately from other assets in
the statement of financial position.
Similarly, assets and liabilities that are part of a disposal group held for sale must be disclosed
separately from other assets and liabilities in the statement of financial position.
This also applies to the assets and liabilities of a discontinued operation.

Example: Presentation of discontinued operations in the statement of financial position

An entity has two disposal groups held for sale:

Disposal group

Group 1 Group 2 Total

Rs. 000 Rs. 000 Rs. 000

Property, plant and equipment 600 300 900

Liabilities (50) (20) (70)

Information relating to discontinued operations might be presented as follows.

© Emile Woolf International 312 The Institute of Chartered Accountants of Pakistan

 Chapter 14: IFRS 5: Non-current assets held for sale and discontinued operations

Example: (continued)

Statement of financial position

Rs. 000
Assets
Non-current assets 2,000
Current assets 720
Non-current assets classified as held for sale (see above) 900
Total assets 3,620

Equity and liabilities

Share capital 1,000
Reserves 1,950
Total equity 2,950
Non-current liabilities 400
Current liabilities 200
Liabilities directly associated with non-current assets classified as held for sale
(see above) 70
Total liabilities 670
Total equity and liabilities 3,620

Note: In this summarised statement of financial position, the non-current assets classified as
‘held for sale’ are the sum of the non-current assets of disposal groups 1 and 2 (Rs. 600,000 +
Rs. 300,000).
Similarly the ‘liabilities directly associated with non-current assets classified as held for sale’ are
the sum of the liabilities for disposal groups 1 and 2.

In the statement of financial position, the comparative figures for the previous year are not restated.
The amount for discontinued operations in the previous year does not include discontinued items
for the current year. The presentation in the statement of financial position therefore differs from
the presentation in the statement of profit or loss.

6.4 Other disclosures

Additional disclosures about discontinued operations must be included in the notes to the financial
statements. These include:
 a description of the non-current asset or disposal group;
 a description of the facts and circumstances of the sale; and
 in the case of operations and non-current assets ‘held for sale’, a description of the facts
and circumstances leading to the expected disposal and the expected manner and timing of
the disposal.
 if applicable, the reportable segment in which the non‑ current asset (or disposal group) is
presented in accordance with IFRS 8 Operating Segments.

© Emile Woolf International 313 The Institute of Chartered Accountants of Pakistan

Advanced accounting and financial reporting

© Emile Woolf International 314 The Institute of Chartered Accountants of Pakistan

 Certified Finance and Accounting Professional

15

CHAPTER
Advanced accounting and financial reporting

IFRS 13: Fair Value Measurement

Contents
1 Introduction to IFRS 13
2 Measurement
3 Valuation techniques
4 Liabilities and an entity’s own equity instruments
5 Disclosure

© Emile Woolf International 315 The Institute of Chartered Accountants of Pakistan

Advanced accounting and financial reporting

1 INTRODUCTION TO IFRS 13
Section overview

 Background
 Definition of fair value
 The asset or liability
 Market participants

1.1 Background
There are many instances where particular IAS / IFRS requires or allows entities to measure or
disclose the fair value of assets, liabilities or their own equity instruments.
Examples include (but are not limited to):

Standard
IFRS 2 Requires an accounting treatment based on the grant date fair value of equity
settled share based payment transactions.
IFRS 3 Measuring goodwill requires the measurement of the acquisition date fair value
of consideration paid and the measurement of the fair value (with some
exceptions) of the assets acquired and liabilities assumed in a transaction in
which control is achieved.
IFRS 7 If a financial instrument is not measured at fair value that amount must be
disclosed.
IFRS 9 All financial instruments are measured at their fair value at initial recognition.
Financial assets that meet certain conditions are measured at amortised cost
subsequently. Any financial asset that does not meet the conditions is measured
at fair value.
Subsequent measurement of financial liabilities is sometimes at fair value.
IFRS 16 Lease transactions
IASs 16/38 Allows the use of a revaluation model for the measurement of assets after initial
recognition.
Under this model, the carrying amount of the asset is based on its fair value at
the date of the revaluation.
IAS 19 Defined benefit plans are measured as the fair value of the plan assets net of
the present value of the plan obligations.
IAS 40 Allows the use of a fair value model for the measurement of investment
property.
Under this model, the asset is fair valued at each reporting date.

Other standards required the use of measures which incorporate fair value.

Standard
IAS 36 Recoverable amount is the higher of value in use and fair value less costs of
disposal.
IFRS 5 An asset held for sale is measured at the lower of its carrying amount and fair
value less costs of disposal.

Some of these standards contained little guidance on the meaning of fair value. Others did contain
guidance but this was developed over many years and in a piecemeal manner.

© Emile Woolf International 316 The Institute of Chartered Accountants of Pakistan

 Chapter 15: IFRS 13: Fair value measurement

Purpose of IFRS 13
The purpose of IFRS 13 is to:
 define fair value;
 set out a single framework for measuring fair value; and
 specify disclosures about fair value measurement.
IFRS 13 does not change what should be fair valued nor when this should occur.
The fair value measurement framework described in this IFRS applies to both initial and
subsequent measurement if fair value is required or permitted by other IFRSs.
Scope of IFRS 13
IFRS 13 applies to any situation where IFRS requires or permits fair value measurements or
disclosures about fair value measurements (and other measurements based on fair value such as
fair value less costs to sell) with the following exceptions.
IFRS 13 does not apply to:
 share based payment transactions within the scope of IFRS 2;
 Leasing transactions accounted for in accordance with IFRS 16 Leases; and
 measurements such as net realisable value (IAS 2 Inventories) or value in use (IAS 36
Impairment of Assets) which have some similarities to fair value but are not fair value.
The IFRS 13 disclosure requirements do not apply to the following:
 plan assets measured at fair value (IAS 19: Employee benefits);
 retirement benefit plan investments measured at fair value (IAS 26: Accounting and reporting
by retirement benefit plans); and
 assets for which recoverable amount is fair value less costs of disposal in accordance with
IAS 36.
1.2 Definition of fair value

Definition: Fair value

Fair value is the price that would be received to sell an asset or paid to transfer a liability in an
orderly transaction between market participants at the measurement date (i.e. it is an exit price).

This definition emphasises that fair value is a market-based measurement, not an entity-specific
measurement. In other words, if two entities hold identical assets these assets (all other things
being equal) should have the same fair value and this is not affected by how each entity uses the
asset or how each entity intends to use the asset in the future.
The definition is phrased in terms of assets and liabilities because they are the primary focus of
accounting measurement. However, the guidance in IFRS 13 also applies to an entity’s own equity
instruments measured at fair value (e.g. when an interest in another company is acquired in a
share for share exchange).
Note that the fair value is an exit price, i.e. the price at which an asset would be sold.

Definition: Exit and entry prices

Exit price: The price that would be received to sell an asset or paid to transfer a liability.
Entry price: The price paid to acquire an asset or received to assume a liability in an exchange
transaction.

© Emile Woolf International 317 The Institute of Chartered Accountants of Pakistan

Advanced accounting and financial reporting

1.3 The asset or liability

A fair value measurement is for a particular asset or liability.
Whether the fair value guidance in IFRS 13 applies to a stand-alone asset or liability or to a group
of assets, a group of liabilities or to a group of assets and liabilities depends on the unit of account
for the item being fair valued.

Definition: Unit of account

Unit of account: The level at which an asset or a liability is aggregated or disaggregated in an IFRS
for recognition purposes.

The unit of account for the asset or liability must be determined in accordance with the IFRS that
requires or permits the fair value measurement.
An entity must use the assumptions that market participants would use when pricing the asset or
liability under current market conditions when measuring fair value. The fair value must take into
account all characteristics that a market participant would consider relevant to the value. These
characteristics might include:
 the condition and location of the asset; and
 restrictions, if any, on the sale or use of the asset.
1.4 Market participants

Definition: Market participants

Market participants: Buyers and sellers in the principal (or most advantageous) market for the
asset or liability.

Market participants have all of the following characteristics:

 They are independent of each other;
 They are knowledgeable, having a reasonable understanding about the asset or liability and
the transaction using all available information, including information that might be obtained
through due diligence efforts that are usual and customary.
 They are able to enter into a transaction for the asset or liability.
 They are willing to enter into a transaction for the asset or liability, i.e. they are motivated but
not forced or otherwise compelled to do so.

© Emile Woolf International 318 The Institute of Chartered Accountants of Pakistan

 Chapter 15: IFRS 13: Fair value measurement

2 MEASUREMENT
Section overview

 Measuring fair value

 Principal or most advantageous market
 Fair value of non-financial assets – highest and best use

2.1 Measuring fair value

Fair value measurement assumes that the asset (liability) is exchanged in an orderly transaction
between market participants to sell the asset (transfer the liability) at the measurement date under
current market conditions.
Sometimes it might be possible to use observable market transactions to fair value an asset or a
liability (e.g. a share might be quoted on the Karachi Stock Exchange). For other assets and
liabilities this may not be possible. However, in each case the objective is the same, being to
estimate the price at which an orderly transaction to sell the asset (or transfer a liability) would take
place between market participants at the measurement date under current market conditions.
Active market
If an active market exists then it will provide information that can be used for fair value
measurement.
 A quoted price in an active market provides the most reliable evidence of fair value and must
be used to measure fair value whenever available.
 It would be unusual to find an active market for the sale of non- financial assets so some
other sort of valuation technique would usually be used to determine their fair value.

Definition: Active market

A market in which transactions for the asset or liability take place with sufficient frequency and
volume to provide pricing information on an ongoing basis.

If there is no such active market (e.g. for the sale of an unquoted business or surplus machinery)
then a valuation technique would be necessary.
2.2 Principal or most advantageous market
Fair value measurement is based on a possible transaction to sell the asset or transfer the liability
in the principal market for the asset or liability.
If there is no principal market fair vale measurement is based on the price available in the most
advantageous market for the asset or liability.

Definitions: Most advantageous market and principal market

Most advantageous market: The market that maximises the amount that would be received to sell
the asset or minimises the amount that would be paid to transfer the liability, after taking into
account transaction costs and transport costs.
Principal market: The market with the greatest volume and level of activity for the asset or liability.

Identifying principle market (or most advantageous market)

It is not necessary to for an entity to make an exhaustive search to identify the principal market (or
failing that, the most advantageous market). However, it should take into account all information
that is reasonably available.
Unless there is evidence to the contrary, principal market (or failing that, the most advantageous
market) is the one in which an entity normally enters into transactions sell the asset or to transfer
the liability being fair valued.

© Emile Woolf International 319 The Institute of Chartered Accountants of Pakistan

Advanced accounting and financial reporting

If there is a principal market for the asset or liability, the fair value measurement must use the
price in that market even if a price in a different market is potentially more advantageous at the
measurement date.
The price in a principle market might either be directly observable or estimated using a valuation
technique.
Transaction costs
The price in the principal (or most advantageous) market used to measure the fair value of the
asset (liability) is not adjusted for transaction costs. Note that:
 fair value is not “net realisable value” or “fair value less costs of disposal”; and
 using the price at which an asset can be sold for as the basis for fair valuation does not
mean that the entity intends to sell it
Transport costs
If location is a characteristic of the asset the price in the principal (or most advantageous) market
is adjusted for the costs that would be incurred to transport the asset from its current location to
that market.

Example: Fair valuation

An entity holds an asset which could be sold in one of two markets.
Information about these markets and the costs that would be incurred if a sale were to be made is
as follows:
Market A Market B
Rs. Rs.
Sale price 260 250
Transport cost (20) (20)
240 230
Transaction cost (30) (10)
Net amount received 210 220
(a) What fair value would be used to measure the asset if Market A were the principal market?
(b) What fair value would be used to measure the asset if no principal market could be
identified?

Answer
(a) If Market A is the principal market for the asset the fair value of the asset would be
measured using the price that would be received in that market, after taking into account
transport costs (Rs. 240).
(b) If neither market is the principal market for the asset, the fair value of the asset would be
measured using the price in the most advantageous market.
The most advantageous market is the market that maximises the amount that would be
received to sell the asset, after taking into account transaction costs and transport costs (i.e.
the net amount that would be received in the respective markets). This is Market B where
the net amount that would be received for the asset would be Rs. 220.
The fair value of the asset is measured using the price in that market (Rs. 250), less
transport costs (Rs. 20), resulting in a fair value measurement of Rs. 230.
Transaction costs are taken into account when determining which market is the most
advantageous market but the price used to measure the fair value of the asset is not
adjusted for those costs (although it is adjusted for transport costs).

© Emile Woolf International 320 The Institute of Chartered Accountants of Pakistan

 Chapter 15: IFRS 13: Fair value measurement

Example: Fair valuation

An entity owns an item of industrial equipment (asset x) for which it wishes to ascertain a fair value
in accordance with IFRS 13.
Information about the markets in which the asset could be sold and the costs that would be
incurred if a sale were to be made is as follows:

Market A Market B
Rs. Rs.
Sale price 500 505
Transport cost (20) (30)
480 475
Volume of sales of asset x (units) 1,000 29,000

(a) Which is the most advantageous market?

(b) What is the fair value of the asset in accordance with IFRS 13?

Answer
a) Market A is the most advantageous market as it provides the highest return after transaction
costs.
b) The fair value of the asset in accordance with IFRS 13 is $505. This is the price available in
the principal market before transaction costs. (The principal market is the one with the
highest level of activity).

Different entities might have access to different markets. This might result in different entities
reporting similar assets at different fair values.
2.3 Fair value of non-financial assets – highest and best use
Fair value measurement of a non-financial asset must value the asset at its highest and best use.
Highest and best use is a valuation concept based on the idea that market participants would seek
to maximise the value of an asset.

Definition: Highest and best use

Highest and best use: The use of a non-financial asset by market participants that would maximise
the value of the asset or the group of assets and liabilities (e.g. a business) within which the asset
would be used.

This must take into account use of the asset that is:
 physically possible;
 legally permissible; and
 financially feasible.
The current use of land is presumed to be its highest and best use unless market or other factors
suggest a different use.

© Emile Woolf International 321 The Institute of Chartered Accountants of Pakistan

Advanced accounting and financial reporting

Example: Highest and best use

X Limited acquired a plot of land developed for industrial use as a factory. A factory with similar
facilities in Karachi and access has recently been sold for Rs. 50 million.
The plot is located on the outskirts of Clifton in Karachi.
Similar sites nearby have recently been developed for residential use as sites for high-rise
apartment buildings.
X Limited determines that the land could be developed as a site for residential use at a cost of Rs.
10 million (to cover demolition of the factory and legal costs associated with the change of use).
The plot of land would then be worth Rs. 62 million.
The highest and best use of the land would be determined by comparing the following:

Rs. million

Value of the land as currently developed 50

Value of the land as a vacant site for residential use

(Rs. 62 million – Rs. 10 million) 52

Conclusion: The fair value of the land is Rs. 52 million.

© Emile Woolf International 322 The Institute of Chartered Accountants of Pakistan

 Chapter 15: IFRS 13: Fair value measurement

3 VALUATION TECHNIQUES
Section overview

 Valuation techniques
 Inputs to valuation techniques
 Fair value hierarchy
 Bid/offer prices

3.1 Valuation techniques

The objective of using a valuation technique is to estimate the price at which an orderly transaction
to sell the asset (or to transfer the liability) would take place between market participants at the
measurement date under current market conditions.
IFRS 13 requires that one of three valuation techniques must be used:
 market approach – uses prices and other relevant information from market transactions
involving identical or similar assets and liabilities;
 cost approach – the amount required to replace the service capacity of an asset (also known
as the current replacement cost);
 income approach – converts future amounts (cash flows, profits) to a single current
(discounted) amount.
An entity must use a valuation technique that is appropriate in the circumstances and for which
sufficient data is available to measure fair value, maximising the use of relevant observable inputs
and minimising the use of unobservable inputs.

3.2 Inputs to valuation techniques

An entity must use valuation techniques that are appropriate in the circumstances and for which
sufficient information is available to measure fair value.
A valuation technique should be used to maximise the use of relevant observable inputs and
minimise the use of unobservable inputs.

Definition: Inputs
Inputs: The assumptions that market participants would use when pricing the asset or liability,
including assumptions about risk, such as the following:
(a) the risk inherent in a particular valuation technique used to measure fair value (such as a
pricing model); and
(b) the risk inherent in the inputs to the valuation technique.

Quoted price in an active market provides the most reliable evidence of fair value and must be
used to measure fair value whenever available.
3.3 Fair value hierarchy
IFRS 13 establishes a fair value hierarchy to categorise inputs to valuation techniques into three
levels.

Definition Examples
Level 1 Quoted prices in active markets Share price quoted on the Lahore Stock
for identical assets or liabilities Exchange
that the entity can access at the
measurement date

© Emile Woolf International 323 The Institute of Chartered Accountants of Pakistan

Advanced accounting and financial reporting

Definition Examples
Level 2 Inputs other than quoted prices Quoted price of a similar asset to the one
included within Level 1 that are being valued.
observable for the asset or Quoted interest rate.
liability, either directly or indirectly.
Level 3 Unobservable inputs for the asset Cash flow projections.
or liability.

3.4 Bid /Offer prices

For some assets (liabilities) markets quote prices that differ depending on whether the asset is
being sold to or bought from the market.
 The price at which an asset can be sold to the market is called the bid price (it is the amount
the market bids for the asset).
 The price at which an asset can be bought from the market is called the ask or offer price (it
is the amount the market asks for the asset or offers to sell it for).
The price within the bid-ask spread that is most representative of fair value in the circumstances
must be used to measure fair value.
Previously, bid price had to be used for financial assets and ask price for financial liabilities but this
is no longer the case.

© Emile Woolf International 324 The Institute of Chartered Accountants of Pakistan

 Chapter 15: IFRS 13: Fair value measurement

4 LIABILITIES AND AN ENTITY’S OWN EQUITY INSTRUMENTS

Section overview

 General principles
 Liabilities and equity instruments held by other parties as assets
 Liabilities and equity instruments not held by other parties as assets
 Financial assets and financial liabilities managed on a net basis

4.1 General principles

Fair value measurement assumes the transfer of an item to a market participant at the
measurement date.
The fair valuation of a liability assumes that it not be settled with the counterparty at the
measurement date but would remain outstanding. In other words, the market participant to whom
the liability could be transferred would be required to fulfil the obligation.
The fair valuation of an entity’s own equity instrument assumes that market participant to whom
the instrument could be transferred would take on the rights and responsibilities associated with
the instrument.
The same guidance that applies to the fair value of assets also applies to the fair value of liabilities
and an entity’s own equity instruments including that:
 an entity must maximise the use of relevant observable inputs and minimise the use of
unobservable inputs; and
 quoted price in an active market must be used to measure fair value whenever available.
In the absence of an active market there might be an observable market for items held by other
parties as assets.

4.2 Liabilities and equity instruments held by other parties as assets

If a quoted price for the transfer of an identical or a similar liability or entity’s own equity instrument
is not available it may be possible to measure fair value from the point of view of a party that holds
the identical item as an asset at the measurement date.
If this is the case fair value is measured as follows:
 using the quoted price in an active market (if available) for the identical item held by another
party as an asset; or failing that
 using other observable inputs (e.g. quoted price in a market that is not active for the identical
item held by another party as an asset); or failing that
 another valuation technique (e.g. using quoted prices for similar liabilities or equity
instruments held by other parties as assets (market approach).
Adjustments to quoted price
There might be factors that are specific to the asset held by the third party that are not applicable
to the fair value of the liability or entity’s own equity.
The quoted price of such items is adjusted for such factors. For example, a quoted price might
relate to a similar (but not identical) liability or equity instrument held by another party as an asset.
However, the price of the asset must not reflect the effect of a restriction preventing the sale of that
asset.

4.3 Liabilities and equity instruments not held by other parties as assets
In this case fair value is measured from the perspective of a market participant that owes the liability
or has issued the claim on equity.

© Emile Woolf International 325 The Institute of Chartered Accountants of Pakistan

Advanced accounting and financial reporting

For example, when applying a present value technique an entity might take into account the future
cash outflows that a market participant would expect to incur in fulfilling the obligation (including
the compensation that a market participant would require for taking on the obligation).

4.4 Financial assets and financial liabilities managed on a net basis

An entity might manage a group of financial assets and financial liabilities on the basis of its net
exposure to either market risks or credit risk.
In this case the entity is allowed to measure the fair value net position (i.e. a net asset or a net
liability as appropriate).
This is an exception to the general rules in IFRS 13 which would otherwise apply separately to the
asset and the liability. It applies only to financial assets and financial liabilities within the scope of
IAS 39: Financial instruments: Recognition and Measurement or IFRS 9: Financial instruments.
The exception is only allowed if the entity does all the following:
 It manages the group of financial assets and financial liabilities on the basis of the entity’s
net exposure to a particular risk (market risk or credit risk of a particular counterparty) in
accordance with its documented risk management or investment strategy;
 It provides information on that basis about the group of financial assets and financial
liabilities to the entity’s key management personnel; and
 It measures those financial assets and financial liabilities at fair value in the statement of
financial position at the end of each reporting period.

© Emile Woolf International 326 The Institute of Chartered Accountants of Pakistan

 Chapter 15: IFRS 13: Fair value measurement

5 DISCLOSURE
Section overview

 Recurring and non-recurring fair value measurement

 Overall disclosure objective
 Disclosures

5.1 Recurring and non-recurring fair value measurement

The fair value measurement of assets and liabilities might be recurring or non-recurring.
 Recurring fair value measurements are those that are required or permitted in the statement
of financial position at the end of each reporting period (e.g. the fair value of investment
property when the IAS 40 fair value model is used);
 Non-recurring fair value measurements are those that are required or permitted in the
statement of financial position in particular circumstances (e.g. when an entity measures an
asset held for sale at fair value less costs to sell in accordance with IFRS 5).
Disclosures are necessary in respect of each of the above.

5.2 Overall disclosure objective

Information must be disclosed to help users assess both of the following:
 the valuation techniques and inputs used to measure the fair value assets and liabilities on
a recurring or non-recurring basis;
 the effect on profit or loss or other comprehensive income for the period of recurring fair
value measurements using significant unobservable inputs (Level 3).
All of the following must be considered to meet the above objectives:
 the level of detail necessary to satisfy the disclosure requirements;
 how much emphasis to place on each of the various requirements;
 how much aggregation or disaggregation to undertake; and
 the need for additional information.

Classes of assets and liabilities

Classes of assets and liabilities must be identified for the purpose of fulfilling the minimum
disclosure requirements of IFRS 15.
Appropriate classes are identified on the basis of the following:
 the nature, characteristics and risks of the asset or liability; and
 the level of the fair value hierarchy within which the fair value measurement is categorised.
5.3 Disclosures
The following information must be disclosed as a minimum for each class of assets and liabilities
measured at fair value in the statement of financial position after initial recognition.

For recurring and non-recurring fair value measurements

The fair value measurement at the end of the reporting period and the reasons for the
measurement for non-recurring fair value measurements
The level of the fair value hierarchy within which the fair value measurements are categorised in
their entirety (Level 1, 2 or 3).

© Emile Woolf International 327 The Institute of Chartered Accountants of Pakistan

Advanced accounting and financial reporting

For fair value measurements categorised within Level 2 and Level 3 of the fair value hierarchy:
 a description of the valuation technique(s) and the inputs used in the fair value measurement
for;
 the reason for any change in valuation technique;
Quantitative information about the significant unobservable inputs used in the fair value
measurement for fair value measurements categorised within Level 3 of the fair value hierarchy.
A description of the valuation processes used for fair value measurements categorised within Level
3 of the fair value hierarchy.
The reason why a non-financial asset is being used in a manner that differs from its highest and
best use when this is the case.

For recurring fair value measurements

The amounts of any transfers between Level 1 and Level 2 of the fair value hierarchy, the reasons
for those transfers and the entity’s policy for determining when transfers between levels are
deemed to have occurred.
For fair value measurements categorised within Level 3 of the fair value hierarchy:
 a reconciliation of opening balances to closing balances, disclosing separately changes
during the period attributable to the following:
 total gains or losses recognised in profit or loss (and the line items in which they are
recognised);
 unrealised amounts included in the above;
 total gains or losses recognised in other comprehensive income (and the line item in
which they are recognised);
 purchases, sales, issues and settlements;
 details of transfers into or out of Level 3 of the fair value hierarchy;
 for recurring fair value measurements categorised within Level 3 of the fair value hierarchy:
 a narrative description of the sensitivity of the fair value measurement to changes in
unobservable inputs;
 the fact that a change to one or more of the unobservable inputs would change fair value
significantly (if that is the case) and the effect of those changes.

Other
If financial assets and financial liabilities are managed on a net basis and the fair value of the net
position is measured that fact must be disclosed.

© Emile Woolf International 328 The Institute of Chartered Accountants of Pakistan

 Certified Finance and Accounting Professional

16

CHAPTER
Advanced accounting and financial reporting

IFRS 15: Revenue from contracts

with customers

Contents
1 Revenue from contracts with customers
2 The five step model
3 Other aspects of IFRS 15

© Emile Woolf International 329 The Institute of Chartered Accountants of Pakistan

Advanced accounting and financial reporting

1 REVENUE FROM CONTRACTS WITH CUSTOMERS

Section overview

 Summary
 Core principle and the five step model

1.1 Summary
IFRS 15:
 establishes a new control-based revenue recognition model;
 changes the basis for deciding whether revenue is recognised at a point in time or over time;
 provides new and more detailed guidance on specific topics; and
 expands and improves disclosures about revenue.

1.2 Core principle and the five step model

IFRS 15 is based on a core principle that requires an entity to recognise revenue:
 in a manner that depicts the transfer of goods or services to customers
 at an amount that reflects the consideration the entity expects to be entitled to in exchange
for those goods or services.
Applying this core principle involves following a five step model as follows:
 Step 1: Identify the contract(s) with the customer
 Step 2: Identify the separate performance obligations
 Step 3: Determine the transaction price
 Step 4: Allocate the transaction price
 Step 5: Recognise revenue when or as an entity satisfies performance obligations

Definitions
Revenue is income arising in the course of an entity’s ordinary activities.
A customer is a party that has contracted with an entity to obtain goods or services that are an
output of the entity’s ordinary activities.

© Emile Woolf International 330 The Institute of Chartered Accountants of Pakistan

 Chapter 16: IFRS 15: Revenue from contracts with customers

2 THE FIVE STEP MODEL

Section overview

 Step 1: Identify the contract(s) with a customer

 Step 2: Identify the separate performance obligations in the contract
 Step 3: Determine the transaction price
 Step 4: Allocate the transaction price to the performance obligations
 Step 5: Recognise revenue when or as an entity satisfies performance obligations

2.1 Step 1: Identify the contract(s) with a customer

The first step in IFRS 15 is to identify the contract. There may be written, oral or implied by an
entity’s customary business practices.
Contract
A contract is an agreement between two or more parties that creates enforceable rights and
obligations.
What are the criteria for identification of a contract?
The general IFRS 15 model applies only if:
(i) the parties have approved the contract;
(ii) the entity can identify each party’s rights (goods and cash);
(iii) the entity can identify the payment terms (for example; payment is to made in 30 days etc.);
(iv) the contract has commercial substance (i.e. the risk, timing or amount of the entity’s future
cash flows is expected to change as a result of the contract); and
(v) it is probable the entity will collect the consideration.
If a contract does not meet any of the above condition will the revenue be recorded?
In this case, revenue is recorded only when either:
(a) the entity’s performance is complete and substantially all of the consideration (cash) has
been collected and it is non-refundable; or
(b) the contract has been terminated and the consideration received is non-refundable.

Example 1:
Mr. Owais agreed on March 1, 2020 to sell 5 cutting machines to Axiom Enterprises. Due to some
deficiency in drafting the agreement each party’s rights cannot be identified. On March 31, 2020
Mr. Owais delivered the goods and these were accepted by Axiom Enterprises. After 10 days of
delivery i.e. April 10, 2020 Axiom Enterprises made the full payment and the payment is non-
refundable.
When should Owais record the revenue?

Answer 1:

Mr. Owais cannot identify each party’s rights so revenue recognition should be delayed until the
entity’s (Owais) performance is complete and substantially all of the consideration (cash) in the
arrangement has been collected and is non-refundable.
Therefore, Mr. Owais should record the revenue on April 10, 2020, as it is the date on which
performance is complete and non-refundable payment is received.

© Emile Woolf International 331 The Institute of Chartered Accountants of Pakistan

Advanced accounting and financial reporting

Example 2:
A CA firm agreed to provide consultancy services to a leading company. A non-refundable advance
of Rs.50,000 is received at the time of agreement on January 1, 2020. The final payment terms
were 30 days from the date of agreement. CA firm would provide consultancy service from the week
beginning January 20 for a month. On 15 January 2020, the contract was terminated.
When should CA firm record the revenue?

Answer 2:

Revenue is recorded when the contract has been terminated and the consideration received is non-
refundable (i-e Rs.50,000). Therefore, revenue should be recorded on 15 January 2020.

Does the contract exist if either party can terminate it?

A contract does not exist if each party (either buyer or seller) has an enforceable right to terminate
a wholly unperformed contract without compensating the other party.

Example 3:
A shopkeeper agreed to deliver 10 computers to Waqas Enterprises within 3 months. As per the
agreement shopkeeper can cancel the contract any time before delivering the computers. In case
of cancellation, shopkeeper is not required to pay any penalty to Waqas Enterprises. Does the
contract exist?

Answer 3:
A contract does not exist if each party (either buyer or seller) has an enforceable right to terminate
a wholly unperformed contract without compensating the other party.
As shopkeeper can cancel contract without compensating Waqas so contract does not exist.

Combination of contracts (What are the situations under which one or more contracts can
be combined)
An entity must combine two or more contracts entered into at or near the same time with the same
customer (or related parties of the customer) and treat them as a single contract if one or more of
the following conditions are present:
 the contracts are negotiated as a package with a single commercial objective;
 the consideration to be paid in one contract depends on the price or performance of the
other contract; or
 the goods or services promised in the contracts (or some goods or services promised in
the contracts) are a single performance obligation

Illustration 1:
Adil Ltd. enters into 2 separate agreements with customer X.
 Agreement 1: Deliver 10,000 bricks for Rs. 100,000
Agreement 2: Build a boundary wall for Rs. 20,000
The two agreements should be combined and considered as a one agreement because contracts
are negotiated with a single commercial objective of building a wall. The price of two agreements
is interdependent. Adil Ltd. is probably charging high price for bricks to compensate for the
discounted price for building the wall.

© Emile Woolf International 332 The Institute of Chartered Accountants of Pakistan

 Chapter 16: IFRS 15: Revenue from contracts with customers

Illustration 2: Combination of contracts for related services

Software Company enters into a contract to sell software to Abdullah Ltd. (AL). Three days later, in
a separate contract, Software Company agrees to provide consulting services to significantly
customize the software to function in AL’s IT environment. AL is unable to use the software until
the customization services are complete.
Software Company determines that the two contracts are combined because they were entered
into at or nearly the same time and with the same customer and the goods and services in the
contracts are inter-dependent therefore a “single performance obligation”.

Examples of contracts which can be combined are as follows:

 Supply and installation of a machine
 Design and building of a house
 Supply of a software and then upgrade the software
Contract modifications
A contract modification is any change in the scope and/or price of a contract approved by both
parties for example, changes in design, quantity, timing or method of performance.
Examples
 Adding a swimming pool in building
 Increase number of items to be supplied
 Extending an IT service contract
If a scope change is approved but the corresponding price change is not yet determined, these
requirements are applied when the entity has an expectation that the price modification will be
approved.
When a contract modification be considered as a separate contract
A contract modification must be accounted for as a separate contract when:
 the scope of the contract increases because of the addition of promised goods or services
that are distinct; and
 the price of the contract increases in a way that reflects the entity’s stand-alone selling
prices of the additional promised goods or services.

Example 1:
Data Co. enters into a 2 year data processing service contract with a customer for Rs. 200,000 (Rs.
100,000 per year)
At end of Year 1, the parties agree to extend the contract for another year for Rs. 80,000 per year
which is also the stand alone selling price.
How should Data Co account for the contract extension?

Answer 1:
Since the additional services provided are ‘distinct’ and the price reflects the stand-alone selling
price, therefore, account for the additional service as a new separate contract.
Following revenue should be recorded in the relevant years.
Year Rs.
1 100,000
2 100,000
3 80,000
Total 280,000

© Emile Woolf International 333 The Institute of Chartered Accountants of Pakistan

Advanced accounting and financial reporting

Example 2:
On 1 September 2020, Abdur Rehman Tyres Co. enters into a contract with Hero Cars Ltd. to sell
1200 tyres for Rs. 3,600,000 (Rs. 3,000 per tyre)
The tyres are to be supplied evenly over a year (100 tyres per month) at each month end. On 1
November 2020, after 200 tyres have been delivered, the contract is modified to require the
delivery of an additional 50 tyres per month. The stand-alone selling price of one tyre has declined
to Rs. 2,500 per tyre.
Assuming year end of organization is December 31.
Calculate the revenue for 2020 and 2021.

Answer 2:
Since the additional goods provided are ‘distinct’ and the price reflects the stand-alone selling price,
therefore, account for the additional service as a new separate contract.
Abdur Rehman Tyres Co. accounts for the additional tyres as being sold under a new and separate
contract:

Revenue 2020 2021 Total

Original contract Rs.1,200,000 Rs.2,400,000 Rs.3,600,000

(4 months x 100 (8 months x 100 units
units x Rs. 3,000) x Rs.3,000)
Additional tyres Rs.250,000 Rs.1,000,000 Rs. 1,250,000
(2 months x 50 (8 months x50 units x
units x Rs.2,500) Rs.2,500)

Total Rs. 1,450,000 Rs. 3,400,000 Rs.4,850,000

2.2 Step 2: Identify the separate performance obligations in the contract

Performance obligations are normally specified in the contract but could also include;
(a) promises implied by an entity’s customary business practices,
(b) published policies or specific statements that create a valid customer expectation that goods
or services will be transferred under the contract.
Performance obligation
A performance obligation is a promise in a contract with a customer to transfer to the customer
either:
(a) a good or service (or a bundle of goods or services) that is distinct; or
(b) a series of distinct goods or services that are substantially the same and that have the same
pattern of transfer to the customer. (for example, electricity, payroll processing and gym
services are consumed by customer as entity delivers them - Here promises are satisfied
over time)
When the goods or services are considered as “distinct”
A good or service is distinct if both of the following criteria are met:
(a) the customer can benefit from the good or service on its own; and
(b) the entity’s promise to transfer the good or service is separately identifiable from other
promises in the contract.

© Emile Woolf International 334 The Institute of Chartered Accountants of Pakistan

 Chapter 16: IFRS 15: Revenue from contracts with customers

Example 1:
Pico Ltd. (PL) sells 10 washing machines for Rs. 20,000 each to a Retailer Co. (RC). PL also provides
the following free of cost:
Free service and maintenance for 3 years
10 kg of washing powder every month for the next 18 months
A discount voucher for a 50% discount if next purchase is made in the next 6 months.
Required:
How many performance obligations are in the contract?

Answer 1:
There are 4 separate performance obligations as all of the goods and services are distinct because
the RC can benefit from the good and service on its own and the PC’s promise to transfer the good
or service is separately identifiable from other promises in the contract:
Following are the separate performance obligations:
Delivery of washing machines (point in time)
Service and maintenance over 3 years (over the time)
10 kg washing powder over the next 18 months (over the time)
Discount voucher (point in time)

Example 2:
A Builder Co. promises “to build Customer X a wall”. Builder Co will delivers the bricks to Customer
X’s premise and then will build the wall for Customer X
How many performance obligations are in the contract?

Answer 2:
There is one single performance obligation
Builder Co. is not just supplying the bricks as distinct good
Bricks and integration are inputs in satisfying the promise of building a wall.

Illustration:
A software house has agreed with Superior Ltd. that it will deliver a software worth Rs.500,000 and
will also provide support service and software updates (Rs.100,000) for two years.
There are 3 performance obligations as customer can benefit from each service independently and
promises of entity are separately identifiable.

2.3 Step 3: Determine the transaction price

An entity must consider the terms of the contract and its customary practices in determining the
transaction price.
The transaction price assumes transfer to the customer will take place as promised and that the
contract will not be cancelled, renewed or modified.
The transaction price is not adjusted for effects of the customer’s credit risk (e.g. bad debts) but
transaction price is adjusted where entity will enforce its right for only a portion of the amount (e.g.
trade discounts).

© Emile Woolf International 335 The Institute of Chartered Accountants of Pakistan

Advanced accounting and financial reporting

Factors to be considered while calculating transaction price

An entity must consider the effects of all the following factors when determining the transaction
price:
Adjustment required in
Sr. No. Description
transaction price
1 Variable consideration The transaction price will be adjusted for performance
bonus, discounts, incentives or penalties
2 Time value of money Transaction price is adjusted for the effects of time value
of money if the contract includes a significant financing
component (e.g. difference between consideration
promised and cash selling price).
3 Non-cash consideration Where a customer promises consideration in a form
other than cash, an entity shall measure the non-cash
consideration at fair value (e.g. shares)
4 Consideration payable to Consideration payable to a customer includes cash
customer amounts that an entity pays to customer. It will be
treated as reduction of the transaction price (i-e
deducted from revenue e.g. vouchers)

Example 1: Variable Consideration

Tayyab Co. enters into a contract to build an oil rig for Rs. 100,000
If the oil rig is not completed on time there will be a Rs. 20,000 penalty
Tayyab Co. has built similar oil rigs before and there is 90% chance that the oil rig will be
completed on time
What is the transaction price?

Answer 1:

Two possible outcomes:

Rs. 100,000 if completed on time
Rs. 80,000 if not completed on time
The “most likely amount” method better predicts the amount of consideration
Therefore, transaction price is Rs. 100,000 as there is 90% chance that the oil rig will be completed
on time.

Example 2: Time Value

Zee Ltd. (ZL) sold a machine on 1 January 2020. The terms of sale are that it will receive Rs.5
million on 31 December 2021. Discount rate is 6% p.a.
Required: Pass the journal entries at the end of financial year 2020 and 2021 for ZL?

Answer 2:
Sale proceeds => 5,000,000 = Rs.4,449,982
(1 + 0.06)^2

Year end (Period covered) Calculation Amount of interest expense

2020 (Interest for the year) (4,449,982 x 6%) 266,999
2021 (Interest for the year) (4,449,982 + 266,999) x 6% 283,019

© Emile Woolf International 336 The Institute of Chartered Accountants of Pakistan

 Chapter 16: IFRS 15: Revenue from contracts with customers

1 January 2020
On dispatch of machine
Debit Credit
Debtor 4,449,982
Sales 4,449,982
31 December 2020
Recognition of interest revenue
Debit Credit
Debtor 266,999
Interest income 266,999
31 December 2021
Recognition of interest revenue
Debit Credit
Debtor 283,019
Interest income 283,019
Recording of final receipt
Debit Credit
Cash (4,449,982 + 266,999 + 283,019) 5,000,000
Debtor 5,000,000

Example 3: Non-cash consideration

AX Ltd. (AXL) decides to take a contract to perform consulting service that would normally be valued
at Rs.50,000. AXL determines that the service is a single performance obligation. AXL agrees to
receive 1,000 shares of customer (Company B). Both accept the contract on 1 January 2020, when
shares are valued at Rs. 50 a share. On 1 February 2020, AXL completes the services, when shares
are valued at Rs. 52 a share.

Answer 3:

AX Ltd. would recognise the revenue of Rs. 52,000 (Rs. 52 x 1,000 shares).

Example 4: Consideration payable to consumer

JJ Ltd. enters into a contract with Dynasty super store (DSS).
DSS commits to buy at least Rs.20 million of items over the next 12 months. The terms of the
contract require JJ Ltd. to make a payment of Rs. 1 million to compensate the DSS for changes that
it will need to make to its retail stores to accommodate the products.
Required:
How much revenue should be recognised by JJ Ltd.?

Answer 4:

The Rs. 1 million paid to the DSS is a reduction of the transaction price and therefore, revenue of
Rs. 19 million will be recorded on satisfaction of performance obligation.

© Emile Woolf International 337 The Institute of Chartered Accountants of Pakistan

Advanced accounting and financial reporting

2.4 Step 4: Allocate the transaction price to the performance obligations

The entity allocates a contract’s transaction price to each separate performance obligation on a
relative “stand-alone” selling price basis at contract inception.
Stand-alone selling price
A stand-alone selling price is the price at which an entity would sell a promised good or service
separately to a customer.

Example 1:
Hero Enterprise enters into a contract for sale, at the beginning of year 2020, of new car and a 3
year service contract for Rs. 1,500,000. The stand-alone selling price of car is Rs. 1,400,000 and
that of services is Rs. 300,000.
Compute the amount of revenue to be recognised at the end of year 2020.

Answer 1:
There are two performance obligations in the given information.
Performance Stand-alone Allocated transaction price Revenue recognised for
obligations price the year ended 2016
Car Rs.1,400,000 Rs. 1,235,294 Rs.1,235,294
(1,400,000/1,700,000x1,500,000)
Service Rs.300,000 Rs. 264,706 Rs.88,235/year
Contract (300,000/1,700,000x1,500,000)
Rs.1,700,000 Rs.1,500,000 Rs.1,323,529

Example 2:
A retailer sells a customer a computer and printer package for Rs. 20,000. The retailer regularly
sells the printer for Rs. 5,000 and the computer for Rs. 18,000.
Required:
Allocate the price to separate performance obligations.

Answer 2:
There are two performance obligations in the given information.
Performance Stand-alone Allocated transaction price
obligations price
Printer Rs.5,000 Rs.4,348 (5,000/23,000 x 20,000)
Computer Rs.18,000 Rs.15,652 (18,000/23,000 x 20,000)
Rs.23,000 Rs.20,000
In this transaction, there is an inherent discount of Rs. 3,000 which does not relate to specific
performance obligation and is therefore allocated to all performance obligations on a relative stand-
alone selling price basis.

What are the methods of estimating stand-alone selling price

Following are the 3 methods for estimating the stand-alone selling price:
 adjusted market assessment approach
 expected cost plus margin approach
 residual approach.

© Emile Woolf International 338 The Institute of Chartered Accountants of Pakistan

 Chapter 16: IFRS 15: Revenue from contracts with customers

Illustration: Adjusted market assessment approach

A manufacturer produced and sold to a customer, a table and a computer for Rs. 13,000. The stand-
alone price of table is Rs. 5,000 and stand-alone price of our computer is not available. In most
recent customer surveys of computer has been given a rating of 3 out of 5 points as against 4 out
of 5 points to competitor’s computer. The stand-alone selling price of competitor computer is Rs.
12,000.
There are two performance obligations in the given transaction.
Performance obligations Stand-alone price Allocated transaction price
Table Rs.2,000 Rs.1,857 (2,000/14,000 x 13,000)
Computer Rs.12,000 Rs.11,143 (12,000/14,000 x 13,000)
Rs.14,000 Rs.13,000

Example 1: Expected Cost Plus Margin Approach

Sohaib Ltd. (SL) sells a machine and one year free technical support for Rs.100,000. It usually sells
the machine for Rs.95,000 but does not sell technical support for this machine as a stand-alone
product. Other support services offered by the SL attract mark up of 50%. It is expected that the
technical support would cost Rs.20,000.
How much of the transaction price should be allocated to the machine and to the technical support?

Answer 1:
The selling price of the machine is 95,000 based on observable prices. There is no observable
selling price of the technical support. Therefore, the stand alone selling price needs to be estimated.
One approach of doing this is the expected cost plus margin approach. Based on this, the selling
price of the service would be 30,000 (20,000 x 150%).
The total stand-alone selling prices of the machine and support are Rs.125,000 (95,000 + 30,000).
However, total consideration receivable is only 100,000. This means customer is receiving a
discount of Rs.25,000.
IFRS 15 says that the entity must consider that whether the discount relates to the whole bundle
or to a particular performance obligation. In the absence of the information, it is assumed that it
relates to the whole bundle.
The transaction price will be allocated as follows:
Performance obligation Stand-alone price Allocation of transaction price
Machine 95,000 76,000
(95,000/125,000 x 100,000)
Services 30,000 24,000
(30,000/125,000 x 100,000)
Total 125,000 100,000

The revenue will be recognised when the performance obligation is satisfied.

Example 2: Residual approach

A retailer sold to a customer, a computer, printer and a scanner package for Rs.15,000. It has
determined that these are three separate performance obligations and regularly sells the printer
for Rs.4,000, the computer for Rs.10,000. This is the first time, manufacturer is going to sell
scanner, hence there is no sale price identified for scanner as stand-alone price.
Required:
Allocate the price to separate performance obligations.

© Emile Woolf International 339 The Institute of Chartered Accountants of Pakistan

Advanced accounting and financial reporting

Answer 2:
There are three performance obligations in the given transaction.
Performance obligation Stand-alone price
Printer 4,000
Computer 10,000
Scanner (balancing) 1,000
15,000

2.5 Step 5: Recognise revenue when or as an entity satisfies performance obligations

When an entity should recognise revenue?
Revenue is recognised when the promised goods or services are transferred to a customer.
 A transfer occurs when the “customer obtains control” of the good or service.
 A customer obtains control of an asset (good or service) when it can direct the use of and
obtain substantially all the remaining benefits from it. Control includes the ability to prevent
other entities from directing the use of and obtaining the benefits from an asset.
The “benefits” of an asset are the potential cash flows that can be obtained directly or indirectly
from the asset in many ways.
What are the indicators when a “control” is considered as transferred to the customer

No. Situation Explanation

1 The entity has a present When the entity has a right to payment, this frequently
right to payment for the indicates that control has passed to the customer.
goods / services
2 The customer has legal title Normally sale should be recorded when entity transfers
the legal title to customer.
Exception
However, some times in “sale on installment basis” entity
retains the legal title to protect collection of money. In
such a case sale is recorded on delivery even if no title
is transferred as it is the time when control is transferred.
3 The customer has physical Normally sale is recorded on physical possession except
possession for bill and hold sales, repurchase agreements and
consignment sales.
4 The customer has the For example, if an entity has sold goods but retains
significant risks and rewards responsibility for delivery to the customer, then the entity
of ownership of the asset likely retains control. However, entities should determine
if some risks of ownership of the asset could be separate
performance obligations, such as an additional
obligation to provide maintenance services for products
that have been delivered. Such risks should be
accounted for separately, and would not impact the
determination of transfer of control.
5 The customer has accepted the asset

Other indicators could arise from the business practices of the entity. Consider a scenario in which
a contract states that a customer has responsibility for damage that occurs during transportation
(FOB shipping point), but the entity has a historical practice of accepting the losses for such
damage. The indicator that legal right has been passed to the customer might be overcome by the
historical practice indicating that the entity still implicitly bears the risks of ownership.

© Emile Woolf International 340 The Institute of Chartered Accountants of Pakistan

 Chapter 16: IFRS 15: Revenue from contracts with customers

Recording revenue at a point in time or over time

 A performance obligation may be satisfied at a point in time (typically for transfer of goods)
or
 A performance obligation may be satisfied over time (typically for provision of services).
Example: Residual approach
Taimoor entered into a construction contract with a customer under following independent terms
of agreement:
For Customer X, Taimoor will build a room on the top floor of premises owned by X.

Answer:
In respect of customer X, Taimoor will record revenue “over time” because control is transferred to
X as and when room is constructed.
Note: Normally in case of construction contract we will assume that performance obligation is
satisfied over time if nothing specific is mentioned in question.

Recording revenue over time

When goods or services are transferred continuously, a revenue recognition method that best
depicts the entity’s performance should be applied (updated as circumstances change).
Methods for measuring revenue over time
Output methods
Outputs are the goods or services finished and transferred to the customer. In other words, the
output method measures results achieved.
This method records revenue by measuring value to customer of goods or services
a) Surveys of work performed;
b) Units produced as a percentage of total units to be produced;
c) Units delivered as a percentage of total units to be delivered; or
d) Contract milestones achieved
Input Methods
The input method is a more indirect measure of fulfilment of a performance obligation. Inputs are
measured by determining how much effort has been put into satisfying a contract e.g.
a) Cost incurred as a percentage of total cost to be incurred.
b) Labour hours used as a percentage of total labour hours to be used;
c) Machine hours used as a percentage of total machine hours to be used;

Example 1:
Umer is developing new computer software for a customer. The contract has not been completed
by the reporting date (31 December 2019). Umer is certain about the outcome. The transaction is
a single performance obligation satisfied over time.
The total revenue will be Rs. 700,000 and total costs are expected to be Rs. 400,000.
Costs of Rs. 150,000 have been incurred to date (31 December 2019).
Umer measure % completion by comparing costs incurred to date against total expected costs.
What revenue should be recognised for the year ended 31 December 2019?

Answer 1:
Revenue for current period is Rs.262,500 (Rs.700,000xRs.150,000/Rs.400,000).
Costs of Rs.150,000 should also be recognised.

© Emile Woolf International 341 The Institute of Chartered Accountants of Pakistan

Advanced accounting and financial reporting

Example 2:
S Limited signed an agreement whereby it is to scrape and re-plaster 50 buildings. The total
contract price is Rs.80,000.
The expected contract cost is Rs.50,000.
The following details are available as at year end, 31 December 20X3:
according to the surveyor, Rs.60,000 of the work had been done and may be invoiced; according to
S Limited, 30 buildings had been scraped and re-plastered; costs of Rs.35,000 have been incurred
to date.
How much revenue should be recorded for 20X3:
a) surveys of work performed
b) services already performed as a percentage of total services to be performed
c) costs incurred to date as a percentage of total expected costs.

Answer 2:
Revenue to be
Sr. Situation Calculation
recorded
a) surveys of work performed - 60,000
b) services already performed as a percentage (80,000 x 30/50) 48,000
of total services to be performed
c) costs incurred to date as a percentage of (80,000 x 56,000
total expected costs. 35,000/50,000)

Overall approach to the 5 steps model

Since you have thoroughly studied the 5 steps model with various illustrative examples, therefore,
try the following examples now.

Example 1:
On 1 November 2019, Shahid receives an order from a customer for 30 computer as well as 12
months of technical support for computers. Shahid delivers the computers (and transfers its legal
title) to the customer on the same day. The customer paid Rs.25,000 upfront. The computer sells
for Rs.20,000 and the technical support sells for Rs.5,000.
How revenue should be recorded for year ended December 31, 2019.

Answer 1:
Below is how the 5 steps would be applied to this contract:
Step 1 - Identify the contract
There is a contract between Shahid and its customer for the provision of goods (computers) and
services (technical support services)
Step 2 – Identify the separate performance obligations within a contract
There are two performance obligations (promises) within the contract:
• The supply of a computer
• The provision of technical support services over a year
Step 3 – Determine the transaction price
The total transaction price is Rs.25,000 per computer.

Step 4 –Allocate the transaction price to the performance obligations in the contract
No need for any allocation as the transaction price and stand-alone price (market price) is same.

© Emile Woolf International 342 The Institute of Chartered Accountants of Pakistan

 Chapter 16: IFRS 15: Revenue from contracts with customers

Step 5 – Recognise revenue when (or as) a performance obligation is satisfied

Computer (Point in time)
Control over the computer has been passed to the customer so the full revenue of Rs. 20,000 for
30 computers (i.e. Rs.600,000) should be recognized immediately.
Technical support services (Over time)
The technical support is provided over time (12 months), so revenue from this should be recognized
over time. For the year ended 31 December 2019, revenue of Rs. 25,000 (Rs.5,000 x 30 x 2/12)
should be recognised from the provision of technical support services.

Example 2:
On 1 January 2020, Bilal enters into a 12-month 'pay monthly' contract for a mobile phone. The
contract is with Mobile Zone and terms of the plan are:
a) Bilal receives a free handset on 1 January 2020.
b) Bilal pays a monthly fee of Rs. 2,000, which includes unlimited free minutes, free SMS for all
network providers and 5 GB free internet services. Bilal is billed on the last day of the month.
Bilal may purchase the same handset from Mobile Zone for Rs. 20,000 without the payment plan.
They may also enter into the payment plan without the handset, in which case the plan costs them
Rs. 1,500 per month.
The company's year-end is 31 December 2020.

Answer 2:
Step 1 - Identify the contract with a customer
Mobile Zone has a 12-month contract with Bilal.
Step 2 - Identify the separate performance obligations in the contract
In this case there are two distinct performance obligations:
1) The obligation to deliver a handset
2) The obligation to provide network services for 12 months
Step 3 - Determine the transaction price
This is straightforward: it is Rs. 24,000, (12 months x monthly fee of Rs. 2,000).
Step 4 - Allocate the transaction price to the separate performance obligations in the contract
The transaction price is allocated to each separate performance obligation in proportion to the
“stand-alone selling price” at contract inception.
Performance Stand-alone Allocated transaction
Revenue (Rs.) Billings
obligations price (Rs.) price (Rs.)
Hand set 20,000 (20,000/38,000 x 12,631* -
24,000)
Network services 18,000 (18,000/38,000 x 11,369 (947 / 2,000 /
(1,500 x 12) 24,000) month**) month
38,000 24,000

Step 5 - Recognise revenue when (or as) the entity satisfies a performance obligation
When the entity transfers a promised good or service to a customer. This applies to each of the
performance obligations:
 When Mobile Zone gives a handset to Bilal, it recognises the revenue of Rs.12,631.
 When Mobile Zone provides network services to Bilal, it needs to recognise the total revenue of
Rs. 11,369. Each month, revenue of Rs. 947 will be recorded.

© Emile Woolf International 343 The Institute of Chartered Accountants of Pakistan

Advanced accounting and financial reporting

3 OTHER ASPECTS OF IFRS 15

Section overview

 Contract costs
 Presentation
 Disclosure

3.1 Contract costs

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

Example: Incremental costs of obtaining a contract

X Limited wins a competitive bid to provide consulting services to a new customer.
X Limited incurred the following costs to obtain the contract:

Rs.
Commissions to sales employees for winning the contract 10,000
External legal fees for due diligence 15,000
Travel costs to deliver proposal 25,000
Total costs incurred 50,000
Analysis
The commission to sales employees is incremental to obtaining the contract and should be
capitalised as a contract asset.
The external legal fees and the travelling cost are not incremental to obtaining the contract because
they have been incurred regardless of whether X Plc obtained the contract or not.

An entity may recognise the incremental costs of obtaining a contract as an expense when incurred
if the amortisation period of the asset that the entity otherwise would have recognised is one year
or less.
Costs to fulfil a contract
Costs incurred in fulfilling a contract might be within the scope of another standard (for example,
IAS 2: Inventories, IAS 16: Property, Plant and Equipment or IAS 38: Intangible Assets). If this is
not the case, the costs are recognised as an asset only if they meet all of the following criteria:
the costs relate directly to a contract or to an anticipated contract that the entity can specifically
identify; the costs generate or enhance resources of the entity that will be used in satisfying (or in
continuing to satisfy) performance obligations in the future; and the costs are expected to be
recovered.

© Emile Woolf International 344 The Institute of Chartered Accountants of Pakistan

 Chapter 16: IFRS 15: Revenue from contracts with customers

Costs that relate directly to a contract might include:

direct labour and direct materials;
allocations of costs that relate directly to the contract or to contract activities; costs that are explicitly
chargeable to the customer under the contract; and other costs that are incurred only because an
entity entered into the contract (e.g. payments to subcontractors).
The following costs must be recognised as expenses when incurred:
general and administrative costs (unless those costs are explicitly chargeable to the customer
under the contract); costs of wasted materials, labour or other resources to fulfil the contract that
were not reflected in the price of the contract; costs that relate to satisfied performance obligations
(or partially satisfied performance obligations) in the contract (i.e. costs that relate to past
performance).
Amortisation and impairment
An asset for contract costs recognised in accordance with this standard must be amortised on a
systematic basis consistent with the transfer to the customer of the goods or services to which the
asset relates.
The amortisation must be updated to reflect a significant change in the entity’s expected timing of
transfer to the customer of the goods or services to which the asset relates.
An impairment loss must be recognised in profit or loss to the extent that the carrying amount of
an asset recognised exceeds:
the remaining amount of consideration that the entity expects to receive in exchange for the goods
or services to which the asset relates; less the costs that relate directly to providing those goods
or services and that have not been recognised as expenses.
When the impairment conditions no longer exist or have improved a reversal of the impairment
loss is recognised. This will reinstate the asset but the increased carrying amount of the asset must
not exceed the amount that would have been determined (net of amortisation) if no impairment
loss had been recognised previously.

Example 1: Amortisation of contract costs

X Limited wins a 5 year contract to provide a service to a customer.
The contract contains a single performance obligation satisfied over time.
X Limited recognises revenue on a time basis
Costs incurred by the end of year 1 and forecast future costs are as follows:

Rs.
Costs to date 10,000
Estimate of future costs 18,000
Total expected costs 28,000
Analysis
Costs must be recognised in the P&L on the same basis as that used to recognise revenue.
X Limited recognises revenue on a time basis, therefore 1/5 of the total expected cost should be
recognised = Rs. 5,600 per annum.

© Emile Woolf International 345 The Institute of Chartered Accountants of Pakistan

Advanced accounting and financial reporting

Example 2: Amortisation of contract costs

X Limited wins a 5 years contract to provide a service to a customer.
The contract is renewable for subsequent one-year periods.
The average customer term is seven years.
The contract contains a single performance obligation satisfied over time.
X Limited recognises revenue on a time basis.
Costs incurred by the end of year 1 and forecast future costs are as follows:

Rs.

Costs to date 10,000

Estimate of future costs 18,000

Total expected costs 28,000

Analysis
Costs must be recognised in the P&L on the same basis as that used to recognise revenue.
X Limited recognises revenue on a time basis. The asset relates to the services transferred to the
customer during the contract term of five years and X Limited anticipates that the contract will be
renewed for two subsequent one-year periods.
Therefore 1/7 of the total expected cost should be recognised = Rs. 4,000 per annum.

Example 3: Amortisation of contract costs

X Limited wins a contract to build an asset for a customer. It is anticipated that the asset will take
2 years to complete
The contract contains a single performance obligation. Progress to completion is measured on an
output basis.
At the end of year 1 the assets is 60% complete.
Costs incurred by the end of year 1 and forecast future costs are as follows:

Rs.

Costs to date 10,000

Estimate of future costs 18,000

Total expected costs 28,000

Analysis
Costs must be recognised in the P&L on the same basis as that used to recognise revenue.
Therefore 60% of the total expected cost should be recognised (Rs. 16,800) at the end of year 1.

3.2 Presentation
This section explains how contracts are presented in the statement of financial position. In order
to do this, it explains the double entries that might result from the recognition of revenue. The
double entries depend on circumstance.
An unconditional right to consideration is presented as a receivable.

© Emile Woolf International 346 The Institute of Chartered Accountants of Pakistan

 Chapter 16: IFRS 15: Revenue from contracts with customers

The accounting treatment to record the transfer of goods for cash or for an unconditional promise
to be paid consideration is straightforward.

Illustration: Possible double entries on recognition of revenue

Debit Credit

Cash X

Receivable X

Revenue X

Example: Double entry – Unconditional right to consideration

1 January 20X8
X Limited enters into a contract to transfer Products A and B to Y Limited in exchange for Rs. 1,000.
Product A is to be delivered on 28 February.
Product B is to be delivered on 31 March.
The promises to transfer Products A and B are identified as separate performance obligations.
Rs.400 is allocated to Product A and Rs.600 to Product B.
X Limited recognises revenue and recognises its unconditional right to the consideration when
control of each product transfers to Y Limited.
The following entries would be required to reflect the progress of the contract).
Contract progress
28 February: X Limited transfers Product A to Y Limited.

At 28 February Dr (Rs.) Cr (Rs.)

Receivables 400

Revenue 400

31 March: X Limited transfers Product B to Y Limited

31 March

Receivables 600

Revenue 600

In other cases, a contract is presented as a contract asset or a contract liability depending on the
relationship between the entity’s performance and the customer’s payment.
Contract assets
A supplier might transfer goods or services to a customer before the customer pays consideration
or before payment is due. In this case the contract is presented as a contract asset (excluding any
amounts presented as a receivable).
A contract asset is a supplier’s right to consideration in exchange for goods or services that it has
transferred to a customer. A contract asset is reclassified as a receivable when the supplier’s right
to consideration becomes unconditional.

© Emile Woolf International 347 The Institute of Chartered Accountants of Pakistan

Advanced accounting and financial reporting

Example: Double entry – Recognition of a contract asset

1 January 20X8
X Limited enters into a contract to transfer Products A and B to Y Limited in exchange for Rs. 1,000.
Product A is to be delivered on 28 February.
Product B is to be delivered on 31 March.
The promises to transfer Products A and B are identified as separate performance obligations.
Rs.400 is allocated to Product A and Rs.600 to Product B.
Revenue is recognised when control of each product transfers to Y Plc.
Payment for the delivery of Product A is conditional on the delivery of Product B. (i.e. the
consideration of Rs. 1,000 is due only after X Limited has transferred both Products A and B to Y
Limited). This means that X Limited does not have a right to consideration that is unconditional (a
receivable) until both Products A and B are transferred to Y Limited.
The following entries would be required to reflect the progress of the contract
Contract progress
The following accounting entries would be necessary:

28 February: X Limited transfers Product A to Y Limited

X Plc does not have an unconditional right to receive the Rs.400 so the amount is recognised as a
contract asset.

At 28 February Dr (Rs.) Cr (Rs.)

Contract asset 400

Revenue 400

31 March: X Limited transfers Product B to Y Limited

X Limited now has an unconditional right to receive the full Rs. 1,000. The Rs.400 previously
recognised as a contract asset is reclassified as a receivable and the Rs.600 for the transfer of
product B is also recognised as receivable.

31 March Dr (Rs.) Cr (Rs.)

Receivable 1,000

Contract asset 400

Revenue 600

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

© Emile Woolf International 348 The Institute of Chartered Accountants of Pakistan

 Chapter 16: IFRS 15: Revenue from contracts with customers

Example: Double entry – Recognition of a contract liability

1 January 20X8
X Limited enters into a contract to transfer Products A and B to Y Limited in exchange for Rs. 1,000.
X Limited can invoice this full amount on 31 January.
Product A is to be delivered on 28 February.
Product B is to be delivered on 31 March.
The promises to transfer Products A and B are identified as separate performance obligations.
Rs.400 is allocated to Product A and Rs.600 to Product B.
Revenue is recognised when control of each product transfers to Y Limited.
The following entries would be required to reflect the progress of the contract
Contract progress
The following accounting entries would be necessary:

At 31 January Dr (Rs.) Cr (Rs.)

Receivable 1,000

Contract liability 1,000

28 February: X Limited transfers Product A to Y Limited

At 28 February Dr (Rs.) Cr (Rs.)

Contract liability 400

Revenue 400

31 March: X Limited transfers Product B to Y Limited

31 March Dr (Rs.) Cr (Rs.)

Contract liability 600

Revenue 600

3.3 Disclosure
The objective of the 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. To achieve that objective, an entity
shall disclose qualitative and quantitative information about all of the following:
(a) its contracts with customers;
(b) the significant judgements, and changes in the judgements, made in applying this Standard to
those contracts; and
(c) any assets recognised from the costs to obtain or fulfil a contract with a customer

© Emile Woolf International 349 The Institute of Chartered Accountants of Pakistan

Advanced accounting and financial reporting

© Emile Woolf International 350 The Institute of Chartered Accountants of Pakistan

 Certified Finance and Accounting Professional

17

CHAPTER
Advanced accounting and financial reporting

IFRS 16: Leases

Contents
1 Introduction and definitions
2 Lease classification
3 Accounting for lease by Lessee
4 Accounting for a finance lease: Lessor accounting
5 Accounting for an operating lease
6 Sale and leaseback transactions
7 Sublease

© Emile Woolf International 351 The Institute of Chartered Accountants of Pakistan

Advanced accounting and financial reporting

1 INTRODUCTION AND DEFINITIONS

Section overview

 Introduction
 Leases
 Types of lessor
 Inception and commencement
 Defined periods
 Residual values
 Lease payments
 Interest rate implicit in the lease
 Initial direct costs
 Lessee's incremental borrowing rate of interest

1.1 Introduction
The previous accounting model for leases as per IAS 17 required lessees and lessors to classify
their leases as either finance leases or operating leases and account for those two types of leases
differently. That model was criticised for failing to meet the needs of users of financial statements
because it did not always provide a faithful representation of leasing transactions. The main reason
is that under IAS 17, lessees were still able to hide certain liabilities resulting from (operating)
leases and simply not present them on the statement of financial position.
IFRS 16 introduces a single lessee accounting model and requires a lessee to recognise assets
and liabilities for all leases with a term of more than 12 months, unless the underlying asset is of
low value or of short term (i-e. 12 months or less). A lessee is required to recognise a right-of-use
asset representing its right to use the underlying leased asset and a lease liability representing its
obligation to make lease payments.

1.2 Leases
IFRS 16 prescribes the accounting treatment of leased assets in the financial statements of lessees
and lessors.

Definition: Lease
A contract or part of a contract that conveys the right to use an asset (the underlying asset) for a
period of time in exchange for consideration.

A lease is a way of obtaining a use of an asset, such as a machine, without purchasing it outright.
The company that owns the asset (the lessor) allows another party (the lessee) to use the asset
for a specified period of time in return for a series of lease payments.
Types of lease
IFRS 16 identifies two types of lease.

Definitions
A lease that transfers substantially all the risks and rewards incidental to ownership of an
underlying asset is known as finance lease.
A lease that does not transfer substantially all the risks and rewards incidental to ownership of an
underlying asset is known as operating lease.

The identification of a lease as a finance lease or an operating lease is crucial as it determines

how a lease is accounted for by the lessor.

© Emile Woolf International 352 The Institute of Chartered Accountants of Pakistan

 Chapter 17: IFRS 16: Leases

This is explained in more detail in later sections.

1.3 Types of lessor

Companies might be lessors as a result of a variety of business models.
Finance companies (often banks and their subsidiaries)
Finance companies provide finance for the purchase of assets. In addition they might finance the
use of assets through leases.
Finance companies are often associated with finance leases but they also fund large operating
leases. Many airlines have use of aircraft through operating leases through finance companies.
Hire companies
These companies own a stock of capital assets which they will lease out for varying periods.
They include:
 tool hire companies;
 plant hire companies; and
 car hire companies
Hire companies are usually involved in operating leases.
Manufacturer/dealer lessors
Some companies make or buy assets to sell. They may offer to lease the asset out as an alternative
to outright sale.
Many motor vehicle manufacturers and dealers do this. Such leases would usually be finance
leases (but not necessarily).
Property companies
Many companies own properties which they lease out to others. These companies might apply IAS
40: Investment Properties to these assets.

1.4 Inception and commencement

Definitions: Inception date of the lease

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

The type of lease in a contract (finance or operating) is identified at the date of inception. This is
where the parties to the lease contract commit to the terms of the contract.

Definition: Commencement date of the lease

The date on which a lessor makes an underlying asset available for use by a lessee.

The accounting treatment required is applied to a lease at the date of commencement. This is the
date that a lessee starts to use the asset or at least, is entitled to start to use the asset.
A lease agreement may allow for an adjustment to the terms of the lease contract during the period
between the inception of the lease and the commencement of the lease term. Such adjustments
might be to take account of unexpected changes in costs (for example the lessor’s costs of making
the asset that is the subject of the lease).
In such cases, the effect of any such changes is deemed to have taken place at the inception of
the lease.

© Emile Woolf International 353 The Institute of Chartered Accountants of Pakistan

Advanced accounting and financial reporting

1.5 Defined periods

IFRS 16 refers to different periods when describing its rules.

Definition: Lease term

The non-cancellable period for which a lessee has the right to use an underlying asset, together
with both:
(a) periods covered by an option to extend the lease if the lessee is reasonably certain to exercise
that option; and
(b) periods covered by an option to terminate the lease if the lessee is reasonably certain not to
exercise that option.

A lease may be split into a primary period followed by an option to extend the lease for a further
period (a secondary period).
In some cases, the lessee might be able to exercise such an option with a small rental or even for
no rental at all. If such an option exists and it is reasonably certain that the lessee will exercise the
option, the second period is part of the lease term.

Definitions: Economic and useful life

Economic life is either:
(a) the period over which an asset is expected to be economically usable by one or more users; or
(b) the number of production or similar units expected to be obtained from the asset by one or
more users.
Useful life is the period over which an asset is expected to be available for use by an entity; or the
number of production or similar units expected to be obtained from an asset by an entity.

Economic life relates to the life of the asset whereas useful life relates to the period that a party
will obtain benefits from that asset.

1.6 Residual values

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

Definition: Unguaranteed residual value and residual value guarantee

Unguaranteed residual value is that portion of the residual value of the underlying asset, the
realisation of which by the lessor is not assured or is guaranteed solely by a party related to the
lessor.
Residual value guarantee is a guarantee made to a lessor by a party unrelated to the lessor that
the value (or part of the value) of an underlying asset at the end of a lease will be at least a specified
amount.

© Emile Woolf International 354 The Institute of Chartered Accountants of Pakistan

 Chapter 17: IFRS 16: Leases

1.7 Lease payments

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

Definition: Lease payments

Payments made by a lessee to a lessor relating to the right to use an underlying asset during the
lease term, comprising the following:
(a) fixed payments (including in-substance fixed payments), less any lease incentives;
(b) variable lease payments that depend on an index or a rate;
(c) the exercise price of a purchase option if the lessee is reasonably certain to exercise that
option; and
(d) payments of penalties for terminating the lease, if the lease term reflects the lessee
exercising an option to terminate the lease.

1.8 Interest rate implicit in the lease

Definition: Interest rate implicit in the lease

The interest rate implicit in the lease is the interest rate that causes the present value of; (a) the
lease payments and (b) the unguaranteed residual value to be equal to the sum of: (i) the fair value
of the underlying asset and (ii) any initial direct costs of the lessor.

The interest rate implicit in the lease is the IRR of the cash flows from the lessor’s viewpoint. It is
the rate that equates the future cash inflows for the lessor to the amount that the lessor invested
in the asset.

Example: Interest rate implicit in the lease

A finance company has purchased an asset for Rs.50,000 and will lease it out in a series of leases
as follows:
The first lease is to Company A for a period of 5 years at an annual rental of Rs.10,000.
After the end of the lease to Company A the asset will be leased to Company B for 1 year at a rental
of Rs.10,000. Company B is a party related to Company A.
After the end of the lease to Company B the asset will be leased to Company C for 1 year at a rental
of Rs.10,000. Company C is not related to Companies A and B.
At the end of this lease the asset is expected to have an unguaranteed residual value of Rs.2,573.
The interest rate implicit in the lease is 10%.
Proof

Time Narrative Lessor’s cash Discount factor Present

flows (10%) value
0 Fair value of the asset (50,000) 1 (50,000)
1 to 7 Lessor’s MLPs 10,000 4.868 48,680
Unguaranteed residual
7 value 2,573 0.513 1,320
50,000
nil

© Emile Woolf International 355 The Institute of Chartered Accountants of Pakistan

Advanced accounting and financial reporting

1.9 Initial direct costs

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

Definition: Initial direct costs

Initial direct costs are incremental costs for obtaining a lease that would not have been incurred if
the lease had not been obtained, except for such costs incurred by a manufacturer or dealer lessor
in connection with a finance lease.

The accounting treatment for initial direct costs will be explained later.
1.10 Lessee's incremental borrowing rate of interest
The interest rate implicit in the lease might be important in deciding whether a lease is a finance
lease or an operating lease.
It is calculated from the lessor’s viewpoint. Sometimes, the lessee might not be able to ascertain
the interest rate implicit in the lease. In that case, it would use the lessee’s incremental borrowing
cost instead.

Definition: Lessee's incremental borrowing rate of interest

The lessee's incremental borrowing rate of interest is the rate of interest that a lessee would have
to pay to borrow over a similar term, and with a similar security, the funds necessary to obtain an
asset of a similar value to the right-of-use asset in a similar economic environment.

© Emile Woolf International 356 The Institute of Chartered Accountants of Pakistan

 Chapter 17: IFRS 16: Leases

2 LEASE CLASSIFICATION
Section overview

 Finance and operating leases (classification relevant to the lessor)

 Identifying a finance lease
 Commentary on finance lease indicators

2.1 Finance and operating leases (classification relevant to the lessor)

IFRS 16 describes two types of lease (with each type being accounted for in a different way):
 finance leases and
 operating leases
A lessor shall classify each of its leases as either an operating lease or a finance lease.
A lease is classified as a finance lease if it transfers substantially all the risks and rewards incidental
to ownership. A lease is classified as an operating lease if it does not transfer substantially all the
risks and rewards incidental to ownership.
Risks may be represented by the possibility of losses from:
 idle capacity;
 technological obsolescence;
 variations in return caused by changes in economic conditions.
Rewards may be represented by the expectation of;
 profitable use of the asset over its economic life;
 gains from increases in value or profits on disposal.
Substance over form
Whether a lease is a finance lease or an operating lease depends on the substance of the
transaction rather than the form of the contract.
The legal form of a finance lease is that the lessor is the legal owner of the underlying asset.
The economic substance of a finance lease is that the lessee has all the benefits and costs
associated with ownership of the asset. The finance lessee is in the same position as it would have
been if it had borrowed money to buy the asset itself. That is why such leases are called finance
leases; they provide finance for the use of an asset.

Example – Substantive substitution right

ABC Ltd enters into a 5 years contract with a freight carrier (XYZ Ltd.) to transport a specified
quantity of goods. XYZ Ltd. uses rail cars of a particular specification, and has a large pool of similar
rail cars that can be used to fulfil the requirements of the contract. The rail cars and engines are
stored at XYZ Ltd. premises when they are not being used to transport goods. Costs associated with
substituting the rail cars are minimal for XYZ Ltd.

In this case, because the rail cars are stored at XYZ Ltd. premises, it has a large pool of similar rail
cars and substitution costs are minimal, the benefits to XYZ Ltd. of substituting the rail cars would
exceed the costs of substituting the cars.
Therefore, XYZ Ltd. substitution rights are substantive and the arrangement does not contain a
lease.

© Emile Woolf International 357 The Institute of Chartered Accountants of Pakistan

Advanced accounting and financial reporting

2.2 Identifying a finance lease

At inception of a contract, an entity shall assess whether the contract is, or contains, a lease. A
contract is, or contains, a lease if the contract conveys the right to control the use of an identified
asset for a period of time in exchange for consideration.
Examples of situations that individually or in combination would normally lead to a lease being
classified as a finance lease are:
(a) the lease transfers ownership of the underlying asset to the lessee by the end of the lease
term;
(b) the lessee has the option to purchase the underlying asset at a price that is expected to be
sufficiently lower than the fair value at the date the option becomes exercisable for it to be
reasonably certain, at the inception date, that the option will be exercised;
(c) the lease term is for the major part of the economic life of the underlying asset even if title is
not transferred;
(d) at the inception date, the present value of the lease payments amounts to at least substantially
all of the fair value of the underlying asset; and
(e) the underlying asset is of such a specialised nature that only the lessee can use it without major
modifications.
Indicators of situations that individually or in combination could also lead to a lease being classified
as a finance lease are:
(a) if the lessee can cancel the lease, the lessor’s losses associated with the cancellation are borne
by the lessee;
(b) gains or losses from the fluctuation in the fair value of the residual accrue to the lessee (for
example, in the form of a rent rebate equaling most of the sales proceeds at the end of the
lease); and
(c) the lessee has the ability to continue the lease for a secondary period at a rent that is
substantially lower than market rent.
In all these situations, it can normally be concluded that substantially all the risks and rewards
incidental to ownership are transferred to the lessee.
These indicators are not always conclusive. Classification should always be based on the
substance of the agreement taking account of all information.
Leases are classified at the inception of the lease. Sometimes, a lessee and lessor agree to change
the provisions of a lease and the changes might be of a sort that would have changed the lease
classification if the new terms had been in effect at the inception of the lease. In these cases, the
revised agreement is regarded as a new agreement over its term.
However, changes in estimates (for example, changes in estimates of the economic life or of the
residual value of the leased property), or changes in circumstances (for example, default by the
lessee), do not give rise to a new classification of a lease for accounting purposes.
The following flowchart may assist entities in making the assessment of whether a contract is, or
contains, a lease.

© Emile Woolf International 358 The Institute of Chartered Accountants of Pakistan

 Chapter 17: IFRS 16: Leases

2.3 Commentary on finance lease indicators

It is not always obvious why the above circumstances indicate that a lease is a finance lease. This
section provides an explanation on some of these.
To understand these, it is useful to think of the terms from the lessor’s viewpoint.
Purchase option
If a lease includes a term whereby the lessee can buy the underlying asset at a bargain price at
the end of the lease that lease is a finance lease.
If the lessor includes this term in the lease, the lessor would expect the lessee to take advantage
of it. Therefore, the lessor knows that it needs to make sure to recover the cost of the asset together
with any related interest during the lease term. The rentals and final sale price are set at a level
which allows it to do this.
If the lease transfers ownership of the underlying asset to the lessee by the end of the lease term
or if the cost of the right-of-use asset reflects that the lessee will exercise a purchase option, the
lessee shall depreciate the right-of-use asset from the commencement date to the end of the useful
life of the underlying asset.

© Emile Woolf International 359 The Institute of Chartered Accountants of Pakistan

Advanced accounting and financial reporting

Therefore, the lessee will pay the full cash price of the asset together with related finance expense
over the lease term.
 The lessee would only do this if it had access to the risks and benefits of ownership
 In substance, this is just like borrowing the cash and buying the asset
Therefore, the lease is a finance lease.
If there is a change in the assessment of an option to purchase the underlying asset, a lessee shall
determine the revised lease payments to reflect the change in amounts payable under the
purchase option.
Lease is for a major part of the expected economic life of the asset
If the lessor includes this term in the lease, the lessor knows that when the asset is given back to
it at the end of the lease, the asset will only have a small value.
Therefore, the lessor knows that it needs to make sure to recover the cost of the asset together
with any related interest during the lease term. The rentals are set at a level which allows it to do
this.
Therefore, the lessee will pay the full cash price of the asset together with related finance expense
over the lease term.
 The lessee would only do this if it had access to the risks and benefits of ownership
 In substance, this is just like borrowing the cash and buying the asset
Therefore, the lease is a finance lease.
Specialised nature of the asset
If the lessor includes this term in the lease, the lessor knows that when the lease comes to an end,
it will be unable to lease the asset on to another party.
Therefore, the lessor knows that it needs to make sure to recover the cost of the asset together
with any related interest during the lease term. The rentals are set at a level which allows it to do
this.
The lessee will pay the full cash price of the asset together with related finance expense over the
lease term.
 The lessee would only do this if it had access to the risks and rewards of ownership.
 In substance, this is just like borrowing the cash and buying the asset.
Therefore, the lease is a finance lease.
PV of future lease payments amounts to substantially all of the fair value of the underlying asset
A lease is a finance lease if at the inception of the lease, the present value of all the future lease
payments amounts to substantially all of the fair value of the underlying asset, or more. (The
discount rate to be used in calculating the present value of the lease payments is the interest rate
implicit in the lease). In this case, the lessee is paying the full cash price of the asset together with
related finance expense over the lease term.

© Emile Woolf International 360 The Institute of Chartered Accountants of Pakistan

 Chapter 17: IFRS 16: Leases

Example: PV of future lease payments

A finance company has purchased an asset to lease out to a manufacturing company.
The asset cost for Rs.500,000 and has an economic life of 10 years.
The lease is for 9 years at an annual rental (in arrears) of Rs.87,000 per annum.
The interest rate implicit in the lease is 10%.
Analysis: Lessor’s view
Discount factor Present
Time Narrative Cash flows (10%) value
1 to 9 Lessor’s LPs 87,000 5.759 501,033
This is more than the fair value of the asset. This lease is a finance lease (also note
that the lease is for the major part of the expected economic life of the asset which
is another finance lease indicator).

Example:
A finance company has purchased an asset for Rs.50,000 and will lease it out in a series of leases
as follows:
The first lease is to Company A for a period of 4 years at an annual rental of Rs.10,000.
After the end of the lease to Company A the asset will be leased to Company B for 3 years at a
rental of Rs.10,000. Company B is not related to Company A.
At the end of this lease the asset is expected to have an unguaranteed residual value of Rs.2,573.
The Interest rate implicit in the lease is 10%.

Analysis: Lessor’s view

Discount factor Present
Time Narrative Cash flows (10%) value
1 to 7 Lessor’s MLPs 10,000 4.868 48,680
This is 97.4% (48,680/50,000  100) of the fair value of the asset.
Most would agree that this was substantially all of the fair value of the asset (though
IFRS 16 does not give a numerical benchmark).
This lease is a finance lease.
Discount factor Present
Time Narrative Cash flows (10%) value
1 to 4 Lessor’s MLPs 10,000 3.170 31,700
This is 63.4% (31,700/50,000  100) of the fair value of the asset.
Most would agree that this is not substantially all of the fair value of the asset
(though IFRS 16 does not give a numerical benchmark).
This lease is an operating lease.

Practice question 1
Jhang Construction has leased a cement lorry. The cash price of the lorry would be
Rs.3,000,000. The lease is for 6 years at an annual rental (in arrears) of Rs.600,000. The
asset is believed to have an economic life of 7 years. The interest rate implicit in the lease
is 7%.
Jhang Construction is responsible for maintaining and insuring the asset.
Required
State with reasons the kind of lease Jhang has entered into.

© Emile Woolf International 361 The Institute of Chartered Accountants of Pakistan

Advanced accounting and financial reporting

3 ACCOUNTING FOR LEASE BY LESSEE

Section overview

 Lease accounting: Initial recognition

 Lease accounting: Subsequent measurement of the asset
 Lease accounting: Subsequent measurement of the liability
 Current and non-current elements of the lease liability
 Presentation
 Disclosure

3.1 Lease accounting: Initial recognition

A lease is capitalised at the commencement of the lease term. This involves the recognition of the
asset that is subject to the lease and a liability for the future lease payments.
At the commencement date, a lessee should recognise a right-of-use asset and a lease liability. It
is the date on which a lessor makes an underlying asset available for use by a lessee.
At the commencement date, a lessee should measure the right-of-use asset at cost.
The cost of the right-of-use asset should comprise:
(a) the amount of the initial measurement of the lease liability;
(b) any lease payments made at or before the commencement date less any lease incentives
received;
(c) any initial direct costs incurred by the lessee;
(d) an estimate of costs to be incurred by the lessee in dismantling and removing the underlying
asset, restoring the site on which it is located or restoring the underlying asset to the
condition required by the terms and conditions of the lease unless those costs are incurred
to produce inventories.
At the commencement date, a lessee shall measure the lease liability at the present value of the
lease payments that are not paid at that date. The lease payments shall be discounted using the
interest rate implicit in the lease, if that rate can be readily determined. If that rate cannot be readily
determined, the lessee shall use the lessee’s incremental borrowing rate.

Illustration:
Debit Credit

Right-of-use X
Lease liability (PV of lease payments) X

Examples of initial direct costs of a lessee include:

– Commissions
– Legal fees*
– Costs of negotiating lease terms and conditions*
– Costs of arranging collateral
– Payments made to existing tenants to obtain the lease
* If they are contingent on origination of the lease

© Emile Woolf International 362 The Institute of Chartered Accountants of Pakistan

 Chapter 17: IFRS 16: Leases

Illustration:
ABC Limited paid Rs.30,000 to a legal advisor to review and advise on lease agreement of a plant
leased by SRT Limited. Procurement Manager of ABC remained involved for a month for negotiating
the lease whose monthly salary paid at Rs.150,000.
Debit Credit
Right-of-use 30,000
Bank 30,000

Salary paid to Procurement Manager is not incidental to this particular lease.

Recognition exemptions
A lessee may elect not to apply the requirements of recognition and measurement of the right-of-
use the leased asset and liability to:
(a) short-term leases; and
(b) leases for which the underlying asset is of low value
Short-term lease
A lease that at the commencement date, has a lease term of 12 months or less. A lease that
contains a purchase option is not a short-term lease.

Example - Applying the short term lease exemption

Lessee ABC enters into an 8-year lease of a machine to be used in manufacturing parts for a plane
that it expects to remain popular with consumers until it completes development and testing of an
improved model. The cost to install the machine in DEF manufacturing facility is not significant.
ABC and DEF each have the right to terminate the lease without a penalty on each anniversary of
the lease commencement date.
The lease term consists of a one-year non-cancellable period because both ABC and DEF have a
substantive termination right
ABC and DEF have a substantive termination right
– both can terminate the lease without penalty
– and the cost to install the machine in DEF manufacturing facility is not significant.
As a result, the lease qualifies for the short-term lease exemption.
Example – Applying the leases of low value exemption
Lessee A is in the pharmaceutical manufacturing and distribution industry and has the following
leases:
– leases of real estate: both office building and warehouse;
– leases of office furniture;
– leases of company cars, both for sales personnel and for senior management and of varying
quality, specification and value;

– leases of trucks and vans used for delivery; and

– leases of IT equipment such as laptops.
A determines that the leases of office furniture and laptops qualify for the recognition exemption
on the basis that the underlying assets, when they are new, are individually of low value. B elects
to apply the exemption to these leases.
As a result, it applies the recognition and measurement requirements in IFRS 16 to its leases of
real estate, company cars, trucks and vans.

© Emile Woolf International 363 The Institute of Chartered Accountants of Pakistan

Advanced accounting and financial reporting

3.2 Lease accounting: Subsequent measurement of the asset

After the commencement date, a lessee should measure the right-of-use asset applying a cost
model, unless it applies either of the measurement models described below
Cost model
To apply a cost model, a lessee should measure the right-of-use asset at cost:
(a) less any accumulated depreciation and any accumulated impairment losses; and
(b) adjusted for any re-measurement of the lease liability.
A lessee should apply the depreciation requirements in IAS 16 Property, Plant and Equipment in
depreciating the right-of-use asset.
If the lease transfers ownership of the underlying asset to the lessee by the end of the lease term
or if the cost of the right-of-use asset reflects that the lessee will exercise a purchase option, the
lessee should depreciate the right-of-use asset from the commencement date to the end of the
useful life of the underlying asset.
Otherwise, the lessee should depreciate the right-of-use asset from the commencement date to
the earlier of the end of the useful life of the right-of-use asset or the end of the lease term.

Other measurement models

If a lessee applies the fair value model in IAS 40 Investment Property to its investment property,
the lessee shall also apply that fair value model to right-of-use assets that meet the definition of
investment property in IAS 40. If right-of-use assets relate to a class of property, plant and
equipment to which the lessee applies the revaluation model in IAS 16, a lessee may elect to apply
that revaluation model to all of the right-of-use assets that relate to that class of property, plant and
equipment.

Example:
Jhang Construction enters into a 6 year lease of a machine on 1 January Year 1.
The fair value of the machine at the commencement of the lease was Rs.80,000 and Jhang
Construction incurred initial direct costs of Rs.2,000 when arranging the lease.
The estimated residual value of the asset at the end of the lease is Rs.8,000.
The estimated useful life of the asset is 5 years.
The accounting policy for similar owned machines is to depreciate them over their useful life on a
straight line basis.

Annual depreciation charge:

Initial cost: Rs.
Fair value of the machine 80,000
Initial direct costs 2,000
82,000
Residual value (8,000)
Depreciable amount 74,000
Useful life (shorter of the lease term and the useful life) 5 years
Annual depreciation charge 14,800

The underlying asset is included in the statement of financial position at its carrying amount (cost
less accumulated depreciation less any accumulated impairment loss (if any)) in the same way as
similar assets.

© Emile Woolf International 364 The Institute of Chartered Accountants of Pakistan

 Chapter 17: IFRS 16: Leases

Example:
Year 1 Year 2 Year 3 Year 4 Year 5
Rs. Rs. Rs. Rs. Rs.
Cost 82,000 82,000 82,000 82,000 82,000

Accumulated depreciation:

Brought forward - 14,800 29,600 44,400 59,200

Charge for the
year 14,800 14,800 14,800 14,800 14,800

Carried forward 14,800 29,600 44,400 59,200 74,000

Carrying amount 67,200 52,400 37,600 22,800 8,000

The asset is depreciated down to a carrying amount at the end of the asset’s useful
life that is the estimated residual value

3.3 Lease accounting: Subsequent measurement of the liability

After the commencement date, a lessee should measure the lease liability by:
(a) increasing the carrying amount to reflect interest on the lease liability;
(b) reducing the carrying amount to reflect the lease payments made; and
(c) re-measuring the carrying amount to reflect any reassessment or lease modifications
After initial recognition, the lease liability is measured at amortised cost using the effective interest
method.
After the commencement date, a lessee should recognise in profit or loss, unless the costs are
included in the carrying amount of another asset applying other applicable Standards, both:
(a) interest on the lease liability; and
(b) variable lease payments not included in the measurement of the lease liability in the period
in which the event or condition that triggers those payments occurs.
Reassessment of the lease liability
After the commencement date, a lessee should re-measure the lease liability by using either
unchanged discount rate or should re-measure the lease liability by discounting the revised
discount rate to reflect changes to the lease payments. A lessee should recognise the amount of
the re-measurement of the lease liability as an adjustment to the right-of-use asset. However, if the
carrying amount of the right-of-use asset is reduced to zero and there is a further reduction in the
measurement of the lease liability, a lessee should recognise any remaining amount of the re-
measurement in profit or loss.
During each year, the lessee makes one or more lease payments. The payment is recorded in the
ledger account as follows.

Illustration:
Debit Credit

Lease liability X
Cash/bank X

© Emile Woolf International 365 The Institute of Chartered Accountants of Pakistan

Advanced accounting and financial reporting

A lease liability is measured in the same way as any other liability. The balance at any point in time
is as follows:

Illustration:
Amount borrowed at the start of the lease (the amount recognised on X
initial recognition of the lease)
Plus: Interest accrued X
Minus: Repayments (lease payments or rentals) (X)
Repayment of loan principal (X)
Amount owed now X

In effect, each lease payment consists of two elements:

 a finance charge (interest charge) on the liability to the lessor, and
 a partial repayment of the liability (the lease obligation).
The finance charge is treated as a finance cost in profit or loss for the period. The partial repayment
of the lease obligation reduces the amount of the liability that remains unpaid.
A lessee shall re-measure the lease liability by discounting the revised lease payments using a
revised discount rate, if either:
(a) there is a change in the lease term. A lessee shall determine the revised lease payments on
the basis of the revised lease term; or
(b) there is a change in the assessment of an option to purchase the underlying asset, assessed
considering the events and circumstances in the context of a purchase option. A lessee shall
determine the revised lease payments to reflect the change in amounts payable under the
purchase option.
Finance charge
The total rental payments over the life of the lease will be more than the amount initially recognised
as a liability. The difference is finance charge.
The total finance charge that arises over the lease term is the difference between the amount
initially recognised as the lease liability and the sum of the lease payments from the standpoint of
the lessee.

Illustration: Total finance charge

Rs.
Lessee’s lease payments (sum of all payments made by the lessee to the lessor) X
Amount on initial recognition (X)
Total finance charge X

Example: Total finance charge

Jhang Construction enters into a 6 year lease of a machine on 1 January Year 1.
The fair value of the machine at the commencement of the lease was Rs.80,000 and Jhang
Construction incurred initial direct costs of Rs.2,000 when arranging the lease.
The annual lease payments are Rs.18,000, payable at the end of each year.
The estimated residual value of the asset at the end of the lease is Rs.8,000 and Jhang
Construction has guaranteed this amount.
The interest rate implicit in the lease is 11.176751%.

© Emile Woolf International 366 The Institute of Chartered Accountants of Pakistan

 Chapter 17: IFRS 16: Leases

Example: Total finance charge (continued)

Total finance charge

Lessee’s lease payments: Rs.
Annual rentals (6  18,000) 108,000
Guaranteed residual value 8,000
116,000
Amount on initial recognition (80,000)*
Total finance charge (interest) 36,000
* This is the amount of the liability, The asset is recognised at Rs.82,000

The finance charge (interest) is recognised over the life of the lease by adding a periodic charge
to the liability for the lease obligation with the other side of the entry as an expense in profit or loss
for the year.

Illustration: Debit Credit

Interest expense X
Lease liability X

Lease modification

Definition: Lease modification

A change in the scope of a lease, or the consideration for a lease, that was not part of the original
terms and conditions of the lease (for example, adding or terminating the right to use one or more
underlying assets, or extending or shortening the contractual lease term).

The first question we have to answer is additional right of use is granted or not?
When the Additional right of use is granted
If the price of the additional right of use commensurate with its standalone price then accounting
for that additional right of use is a new separate contract.
A lessee should account for a lease modification as a separate lease if both:
(a) the modification increases the scope of the lease by adding the right to use one or more
underlying assets; and
(b) the consideration for the lease increases by an amount commensurate with the stand-alone
price for the increase in scope and any appropriate adjustments to that stand-alone price to
reflect the circumstances of the particular contract.
When the Additional right of use not granted
When the price of the additional right of use does not commensurate with its standalone price then
For a lease modification that is not accounted for as a separate lease, at the effective date of the
lease modification a lessee should:
(a) allocate the consideration in the modified contract. Following is the guidance for allocating
the consideration received;
i. For a contract that contains a lease component and one or more additional lease or non-
lease components, a lessee should allocate the consideration in the contract to each
lease component on the basis of the relative stand-alone price of the lease component
and the aggregate stand-alone price of the non-lease components.

© Emile Woolf International 367 The Institute of Chartered Accountants of Pakistan

Advanced accounting and financial reporting

ii. The relative stand-alone price of lease and non-lease components should be determined
on the basis of the price the lessor, or a similar supplier, would charge an entity for that
component, or a similar component, separately. If an observable stand-alone price is
not readily available, the lessee should estimate the stand-alone price, maximising the
use of observable information.
However, as a practical expedient, a lessee may elect, by class of underlying asset, not
to separate non-lease components from lease components, and instead account for
each lease component and any associated non-lease components as a single lease
component.
(b) determine the lease term of the modified lease; and
(c) remeasure the lease liability by discounting the revised lease payments using a revised
discount rate. The revised discount rate is determined as the interest rate implicit in the lease
for the remainder of the lease term, if that rate can be readily determined, or the lessee’s
incremental borrowing rate at the effective date of the modification, if the interest rate implicit
in the lease cannot be readily determined.
For a lease modification that is not accounted for as a separate lease, the lessee should account
for the re-measurement of the lease liability by:
(a) decreasing the carrying amount of the right-of-use asset to reflect the partial or full
termination of the lease for lease modifications that decrease the scope of the lease. The
lessee should recognise in profit or loss any gain or loss relating to the partial or full
termination of the lease.
(b) making a corresponding adjustment to the right-of-use asset for all other lease modifications.
The following are examples of lease modifications that may be negotiated after the lease
commencement date:
 A lease extension
 Early termination of the lease
 A change in the timing of lease payments
 Leasing additional space in the same building

Example: Modification that is a separate new lease

Anayat Ltd. (AL) enters into a 5-year lease for 1,500 square feet of warehouse space with Fahim
Ltd. (FL) for Rs.10,000 per month. At the end of year one, AL and FL agree to amend their lease
contract to include an additional 1,000 square feet of warehouse space in the same building for
the remaining four years of the lease. Anayat Ltd. pays an additional Modification and
remeasurement of a lease Rs.6,000 per month for the additional space. The additional Rs.6,000 is
in line with the current market rate to lease 1,000 square feet of warehouse space in that particular
building at the date that the modification is agreed to. Anayat Ltd. will make one monthly payment
of Rs.16,000 per month after the modification.
Required:
How should Anayat Ltd. account for this lease modification?
Analysis
Anayat Ltd. should account for the lease modification as a separate lease because the modification
granted AL an additional right-of-use at a price that is commensurate with the standalone price for
the additional space. Therefore, on the new lease’s commencement date, AL would have two
separate leases:
 The original lease for 2,000 square feet for five years
 A new lease for the additional 1,000 square feet for four years
The accounting for the original lease is not impacted by the modification. Beginning on the effective
date of the modification, AL would have two separate leases, each of which contains a single lease
component the original, unmodified lease and the new lease.

© Emile Woolf International 368 The Institute of Chartered Accountants of Pakistan

 Chapter 17: IFRS 16: Leases

Lessee reassessment of short-term lease exception

A lessee should reassess whether a short-term lease continues to qualify for the short-term lease
exception when either of the following events occur:
 Modification and remeasurement of a lease
 The lease term changes (e.g., because the lessee elects to exercise its renewal option) such
that, after the change, the remaining lease term extends more than 12 months from the end of
the previously determined lease term
 The lessee becomes reasonably certain to exercise its option to purchase the underlying asset

3.4 Current and non-current elements of the lease liability

The total liability must be divided between:
 the current liability (amount payable within the next 12 months), and
 the non-current liability.
The easy way to do it is to use the tables to identify the current liability or the non-current liability
and then find the other as a balancing figure.

Example: Split of current and non-current liability at the end of year 1

Opening Lease Capital Closing

Year balance payments Interest repayments balance
1 80,000 (18,000) 8,941 (9,059) 70,941
2 70,941 (18,000) 7,929 (10,071) 60,870
 
This is the This is the
current non-current
liability liability
Liability: Rs.
Current liability 10,071
Non-current liability 60,870
Total liability (for proof) 70,941

3.5 Presentation
On the face of balance sheet, the right-of-use asset can be presented either separately or in the
same line item in which the underlying asset would be presented. The lease liability can be
presented either as a separate line item or together with other financial liabilities. If the right-of-use
asset and the lease liability are not presented as separate line items, an entity discloses in the
notes the carrying amount of those items and the line item in which they are included.
In the statement of profit or loss and other comprehensive income, the depreciation charge of the
right-of-use asset is presented in the same line item/items in which similar expenses (such as
depreciation of property, plant and equipment) are shown. The interest expense on the lease
liability is presented as part of finance costs. However, the amount of interest expense on lease
liabilities has to be disclosed in the notes.
In the statement of cash flows, lease payments are classified consistently with payments on other
financial liabilities:
 The part of the lease payment that represents cash payments for the principal portion of the
lease liability is presented as a cash flow resulting from financing activities.

© Emile Woolf International 369 The Institute of Chartered Accountants of Pakistan

Advanced accounting and financial reporting

 The part of the lease payment that represents interest portion of the lease liability is
presented either as an operating cash flow or a cash flow resulting from financing activities
(in accordance with the entity’s accounting policy regarding the presentation of interest
payments).
 Payments on short-term leases, for leases of low-value assets and variable lease payments
not included in the measurement of the lease liability are presented as an operating cash
flow.

3.6 Disclosures
A lessee shall disclose information about its leases for which it is a lessee in a single note or
separate section in its financial statements. However, a lessee need not duplicate information that
is already presented elsewhere in the financial statements, provided that the information is
incorporated by cross-reference in the single note or separate section about leases.
A lessee shall disclose the following amounts for the reporting period:
(a) depreciation charge for right-of-use assets by class of underlying asset;
(b) interest expense on lease liabilities;
(c) the expense relating to short-term leases. This expense need not include the expense
relating to leases with a lease term of one month or less;
(d) the expense relating to leases of low-value assets. This expense shall not include the
expense relating to short-term leases of low-value assets;
(e) the expense relating to variable lease payments not included in the measurement of lease
liabilities;
(f) income from subleasing right-of-use assets;
(g) total cash outflow for leases;
(h) additions to right-of-use assets;
(i) gains or losses arising from sale and leaseback transactions; and
(j) the carrying amount of right-of-use assets at the end of the reporting period by class of
underlying asset.
A lessee shall provide the disclosures specified in a tabular format, unless another format is more
appropriate. The amounts disclosed shall include costs that a lessee has included in the carrying
amount of another asset during the reporting period.
A lessee shall disclose the amount of its lease commitments for short-term leases accounted if the
portfolio of short-term leases to which it is committed at the end of the reporting period is dissimilar
to the portfolio of short-term leases to which the short-term lease expense disclosed (See
disclosure (c) as discussed in the preceding paragraph).
If right-of-use assets meet the definition of investment property, a lessee shall apply the disclosure
requirements in IAS 40. In that case, a lessee is not required to provide the disclosures in preceding
paragraph (a), (f), (h) or (j) for those right-of-use assets.
If a lessee measures right-of-use assets at revalued amounts applying IAS 16, the lessee shall
disclose the information specified in relevant disclosure of IAS 16, for those right-of-use assets.

© Emile Woolf International 370 The Institute of Chartered Accountants of Pakistan

 Chapter 17: IFRS 16: Leases

4 ACCOUNTING FOR A FINANCE LEASE: LESS0R ACCOUNTING

Section overview

 Definitions
 Finance lease accounting
 Manufacturer/dealer lessors
 Finance lessor disclosures

4.1 Definitions
The lessor does not record the leased asset in his own financial statements because he has
transferred the risks and rewards of ownership of the leased asset to the lessee. Instead, he
records the amount due to him under the terms of the finance lease as a receivable.
The receivable is described as the net investment in the lease.

Definitions: Gross and net investment in the lease

Gross investment in the lease is the aggregate of:
(a) the lease payments receivable by the lessor under a finance lease, and
(b) any unguaranteed residual value accruing to the lessor.
Net investment in the lease is the gross investment in the lease discounted at the interest rate
implicit in the lease.

An earlier section explained that the interest rate implicit in the lease is the discount rate that, at
the inception of the lease, causes the present value of the lease payments and the unguaranteed
residual value to be equal to the sum of the fair value of the underlying asset and any initial direct
costs of the lessor.
Therefore, the net investment in the lease is the sum of the fair value of the asset plus the initial
direct costs.

Definition: Unearned finance income

Is the difference between:
a) the gross investment in the lease; and
b) the net investment in the lease.

4.2 Finance lease accounting

Many of the entries to be made in the ledger accounts of the lessor are a ‘mirror image’ of those
made by the lessee in respect of his lease liability.

Lessee Lessor

Initial recognition & Lease payments payable Finance lease receivable (net
measurement investment in the lease)

Subsequent measurement Finance cost Finance income

Pattern of recognition So as to provide a constant So as to provide a constant

periodic rate of charge on the periodic rate of return on the
outstanding obligation net investment in the lease.

© Emile Woolf International 371 The Institute of Chartered Accountants of Pakistan

Advanced accounting and financial reporting

Initial recognition
The lessor records a receivable for the capital amount owed by the lessee. This should be stated
at the amount of the ‘net investment in the lease’.

Illustration: Double entry on Initial recognition of a finance lease

Debit Credit

Net investment in the lease X

Cash/bank X

For finance leases other than those involving manufacturer or dealer lessors, initial direct costs are
included in the initial measurement of the finance lease receivable thus reducing the amount of
income recognised over the lease term to below what it would have been had the costs not been
treated in this way. The result of this is that the initial direct costs are recognised over the lease
term as part of the income recognition process.
Initial direct costs of manufacturer or dealer lessors in connection with negotiating and arranging a
lease are excluded from the definition of initial direct costs. As a result, they are excluded from the
net investment in the lease.
The treatment of similar costs incurred by manufacturers and dealers is explained later.
Subsequent measurement of the receivable
During each year, the lessor receives payments from the lessee. Each receipt is recorded in the
ledger account as follows.

Illustration: Lessor receipts Debit Credit

Cash/bank X
Net investment in the lease X

A finance lease receivable (net investment in the lease) is measured in the same way as any other
financial asset. The balance at any point in time is as follows:

Illustration: Net investment in the lease Rs.

Amount of loan at the start of the lease (the amount recognised on X

initial recognition of the lease)
Plus: Interest accrued X
Minus: Repayments (lease payments or rentals) (X)
Repayment of loan principal (X)
Amount owed to the lessor now. X

In effect, each lease receipt consists of two elements:

 finance income on the receivable; and
 a partial repayment of the receivable (net investment in the lease).
The finance charge is recognised as income in profit or loss for the period. The partial repayment
of the lease receivable reduces the amount owed to the lessor.
Finance income
The total rental receipts over the life of the lease will be more than the amount initially recognised
as a receivable. The difference is finance income.
The total finance income that arises over the life of the lease is the difference between the amount
invested in the lease (the amount loaned plus the initial direct costs) and the sum of all receipts.

© Emile Woolf International 372 The Institute of Chartered Accountants of Pakistan

 Chapter 17: IFRS 16: Leases

Illustration: Total finance income

Rs.
Lessor’s lease payments X
Initial direct costs X
X
Amount on initial recognition (X)
Total finance income X

Example: Total finance income

Sialkot Finance agreed to lease a machine to Jhang Construction commencing on 1 January Year 1.
The lease was a 6 year finance lease of a machine on 1 January Year 1 with annual lease payments
of Rs.18,000, payable in arrears.
The fair value of the machine at the commencement of the lease was Rs.80,000 and Sialkot
Finance incurred initial direct costs of Rs.2,000 when arranging the lease.
The estimated residual value of the asset at the end of the lease is Rs.10,000. The lessee has
guaranteed an amount of Rs.8,000.
The interest rate implicit in the lease is 10.798%.
Total finance income
Lessor’s lease payments: Rs.
Annual rentals (6  18,000) 108,000
Guaranteed residual value 8,000
Unguaranteed residual value 2,000
118,000
Amount on initial recognition (80,000)
Initial direct costs (2,000)
(82,000)
Total finance income 36,000

The finance income is recognised over the life of the lease by adding a periodic return to the net
investment in the lease with the other side of the entry as income in profit or loss for the year.

Illustration:
Debit Credit

Net investment in the lease X

Statement of comprehensive income: finance income X

4.3 Manufacturer/dealer lessors

Manufacturers or dealers often offer to customers the choice of either buying or leasing an asset.
A finance lease of an asset by a manufacturer or dealer lessor gives rise to two types of income:
 profit or loss equivalent to the profit or loss resulting from an outright sale of the asset being
leased, at normal selling prices, reflecting any applicable volume or trade discounts; and
 finance income over the lease term.

© Emile Woolf International 373 The Institute of Chartered Accountants of Pakistan

Advanced accounting and financial reporting

Revenue
The sales revenue recognised at the commencement of the lease term is the lower of:
 the fair value of the underlying asset; and
 the present value of the lease payments accruing to the lessor discounted at market rate of
interest.
Cost of sale
The cost of sale recognised at the commencement of the lease term is the carrying amount of the
underlying asset less the present value of the unguaranteed residual value.
The deduction of the present value of the unguaranteed residual value recognises that this part of
the asset is not being sold. This amount is transferred to the lease receivable. The balance on the
lease receivable is then the present value of the amounts which the lessor will collect off the lessee
plus the present value of the unguaranteed residual value. This is the net investment in the lease
as defined in section 5.2.
Costs incurred by manufacturer or dealer lessors in connection with negotiating and arranging a
lease must be recognised as an expense when the selling profit is recognised.
Profit or loss on the sale
The difference between the sales revenue and the cost of sale is the selling profit or loss. Profit or
loss on these transactions is recognised in accordance with the policy followed for recognising
profit on outright sales.
The manufacturer or dealer might offer artificially low rates of interest on the finance transaction.
In such cases the selling profit is restricted to that which would apply if a market rate of interest
were charged.

Example: Manufacturer or dealer leases

Multan Motors is a car dealer.
It sells cars and offers a certain model for sale by lease.
The following information is relevant:
Price of the car in a cash sale Rs.2,000,000
Cost of the car Rs.1,500,000
Finance option:
Annual rental Rs.804,230
Lease term 3 years
Interest rate 10%
Estimated residual value nil
Lessor’s cost of setting up the lease Rs.20,000

Discount factor
t1 to t3 @ 10% 2.486852 (written as 2.487)

Working: Revenue – lower of: Rs.

Fair value of the asset 2,000,000
Present value of the lease payments
804,230  2.487 2,000,000

© Emile Woolf International 374 The Institute of Chartered Accountants of Pakistan

 Chapter 17: IFRS 16: Leases

Example: Manufacturer or dealer leases (continued)

Multan Motors is a car dealer.
It sells cars and offers a certain model for sale by lease.
The following information is relevant:
Initial double entry:
Revenue Debit Credit
Lease receivable (Net investment in the lease) 2,000,000
Statement of comprehensive income 2,000,000
Cost of sale
Statement of comprehensive income 1,500,000
Asset (Inventory) 1,500,000
Cost of setting up the lease
Statement of comprehensive income 20,000
Cash/bank 20,000

Net investment in the lease (over its life):

Opening net Lease Closing net

Year investment Interest (10%) receipts investment
1 2,000,000 200,000 (804,230) 1,395,770
2 1,395,770 139,577 (804,230) 731,117
3 731,117 73,113 (804,230) nil

The interest income is calculated by multiplying the opening receivable by 10% in each year
(so as to provide a constant rate of return on the net investment in the lease).

Summary of double entry in year 1:

Net investment
Bank Inventory in the lease Profit or loss
B/f 1,500,000Dr
Revenue 2,000,000Dr 2,000,000Cr
Cost of sales (1,500,000)Cr (1,500,000)Dr
Set up cost (20,000)Cr (20,000)Dr
Profit on sale 480,000Cr

Lease income 200,000Dr 200,000Cr

Lease rental 804,230Dr (804,230)Cr
1,395,770Dr 680,000Cr

© Emile Woolf International 375 The Institute of Chartered Accountants of Pakistan

Advanced accounting and financial reporting

Example: Manufacturer or dealer leases with unguaranteed residual value

The following information is relevant:
Price of the car in a cash sale Rs.2,000,000
Cost of the car Rs.1,500,000
Finance option:
Annual rental Rs.764,018
Lease term 3 years
Interest rate 10%
Estimated residual value Rs.133,100
Lessor’s cost of setting up the lease Rs.20,000
Discount factors:
t3 @ 10% 0.7513148 (written as 0.751)
t1 to t3 @ 10% 2.486852 (written as 2.487)
Workings
W1: Revenue – lower of: Rs.
Fair value of the asset 2,000,000
Present value of the lease payments
764,018 2.487 1,900,000
W2: Present value of the unguaranteed residual value
Present value of the lease payments
133,156  0.751 100,000
Initial double entry:
Revenue Debit Credit
Lease receivable (Net investment in the lease) 1,900,000
Statement of comprehensive income 1,900,000
Cost of sale
Statement of comprehensive income 1,400,000
Asset (Inventory) 1,400,000
Transfer
Lease receivable (Net investment in the lease) 100,000
Asset (Inventory) 100,000
Cost of setting up the lease
Statement of comprehensive income 20,000
Cash/bank 20,000
Opening net Lease Closing net
Year investment Interest (10%) receipts investment
1 1,900,000
100,000
2,000,000 200,000 (764,018) 1,435,982
2 1,435,982 143,598 (764,018) 815,562
3 815,562 81,556 (764,018) 133,100
The interest income is calculated by multiplying the opening receivable by 10% in each year
(so as to provide a constant rate of return on the net investment in the lease).
The balance on the account at the end of the lease term is the unguranteed residual value.

© Emile Woolf International 376 The Institute of Chartered Accountants of Pakistan

 Chapter 17: IFRS 16: Leases

Net investment in the lease (over its life):

Summary of double entry in year 1:
Net investment
Bank Inventory Profit or loss
in the lease
B/f 1,500,000Dr
Revenue 1,900,000Dr 1,900,000Cr
Cost of sales (1,400,000)Cr (1,400,000)Dr
Set up cost (20,000)Cr (20,000)Dr
Profit on sale 480,000Cr

Transfer (100,000)Cr 100,000Dr

Lease income 200,000Dr 200,000Cr

Lease rental 764,018Dr (764,018)Cr
1,435,982Dr 680,000Cr
A motor dealer acquires vehicles of a particular model from the manufacturer for Rs.21,000, a
20% discount on the recommended retail price of Rs.26,250. It offers them for sale at the
recommended retail price with 0% finance over three years, provided three annual payments of
Rs.8,750 are made in advance. The market rate of interest is 8%.
A sale transaction made on 1 January 20X5 is recognised as a combination of an outright sale
and a finance lease. The present value of the minimum lease payments is treated as the
consideration for the outright sale and at 8% is calculated as follows:
Year Cash flow Discount factor at 8% Present value
Rs. Rs.
20X5 8,750 1.000 8,750
1
20X6 8,750 8,102
(1.08)= 0.926
1
20X7 8,750 7,499
(1.08)2=0.857
24,351
Requirement
How should the transaction be recognised by the dealer in the year ending 31 December 20X5?
Statement of comprehensive income
Revenue (lower of FV Rs.26,250 and PV of MLPs Rs.24,351) 24,351
Cost of sales (lower of cost and CV — PV of unguaranteed residual value) (21,000)
Profit 3,351
Finance income: (Working) 1,248
Statement of financial position
Receivable (Working) 16,849
WORKING
Bal b/f Installments c/f Interest Bal c/f 8% 31
in advance income at Dec
Rs. Rs. Rs. Rs. Rs.
20X5 24,351 (8,750) 15,601 1,248 16,849

© Emile Woolf International 377 The Institute of Chartered Accountants of Pakistan

Advanced accounting and financial reporting

4.4 Finance lessor disclosures

A finance lessor must disclose the following:
 selling profit or loss;
 finance income on the net investment in the lease; and
 income relating to variable lease payments not included in the measurement of the net
investment in the lease.
 a reconciliation between the gross investment in the lease at the end of the reporting period,
and the present value of lease payments receivable at the end of the reporting period;
 the gross investment in the lease and the present value of lease payments receivable at the
end of the reporting period, for each of the following periods:
 not later than one year;
 later than one year and not later than five years;
 later than five years;
 unearned finance income;
 the unguaranteed residual values accruing to the benefit of the lessor;
 the accumulated allowance for uncollectible lease payments receivable;
 contingent rents recognised as income in the period;
 a general description of the lessor's material leasing arrangements.
 Maturity analysis of lease payment receivables
A lessor shall provide a qualitative and quantitative explanation of the significant changes in the
carrying amount of the net investment in finance leases.
A lessor shall disclose additional qualitative and quantitative information about;
 the nature of the lessor’s leasing activities; and
 how the lessor manages the risk associated with any rights it retains in underlying assets.
In particular, a lessor shall disclose its risk management strategy for the rights it retains in
underlying assets, including any means by which the lessor reduces that risk.

© Emile Woolf International 378 The Institute of Chartered Accountants of Pakistan

 Chapter 17: IFRS 16: Leases

5 ACCOUNTING FOR AN OPERATING LEASE

Section overview

 Operating leases in the financial statements of the lessor

 Operating lessor disclosures

5.1 Operating leases in the financial statements of the lessor

Because the lessor has not transferred the risks and rewards of ownership of the physical asset to
the lessee, the lessor shows the leased asset as a non-current asset in its statement of financial
position.
It will be shown in an appropriate category of property, plant and equipment as an investment
property at its carrying value (cost/valuation minus accumulated depreciation).
In respect of the leased asset, the lessor’s annual statement of comprehensive income will include
in profit or loss:
 depreciation on the asset as an expense, and
 rental income (from the lessee, this is usually calculated on a straight-line basis).
Lease income from operating leases is recognised in income on a straight-line basis over the lease
term, unless another systematic basis is more representative of the time pattern in which use
benefit derived from the leased asset is diminished.
Initial direct costs incurred by lessors in negotiating and arranging an operating lease are added to
the carrying amount of the leased asset and recognised as an expense over the lease term on the
same basis as the lease income.
The depreciation policy for depreciable leased assets must be consistent with the lessor's normal
depreciation policy for similar assets, and calculated in accordance with IAS 16 and IAS 38.
A lessor shall apply IAS 36 to determine whether an underlying asset subject to an operating lease
is impaired and to account for any impairment loss identified.
Manufacturer/dealer lessors
A manufacturer or dealer lessor must not recognise any selling profit on entering into an operating
lease. It is not the equivalent of a sale as the risks and benefits of ownership do not pass.
Operating Lease Modification
A lessor shall account for a modification to an operating lease as a new lease from the effective
date of the modification, considering any prepaid or accrued lease payments relating to the original
lease as part of the lease payments for the new lease.

5.2 Operating lessor disclosures

A lessor shall disclose the lease income, separately disclosing income relating to variable lease
payments that do not depend on an index or a rate. A lesser shall provide the specified disclosures
in a tabular format, unless another format is more appropriate.
In order to achieve the disclosure objective, a lessor shall disclose additional qualitative and
quantitative information about its leasing activities.
This additional information includes, but is not limited to, information that helps users of financial
statements to assess:
 the nature of the lessor’s leasing activities; and
 How the lessor manages the risk associated with any rights it retains in underlying assets.
In particular, a lessor shall disclose its risk management strategy for the rights it retains in
underlying assets, including any means by which the lessor reduces that risk. Such means
may include, for example, buy-back agreements, residual value guarantees or variable lease
payments for use in excess of specified limits.

© Emile Woolf International 379 The Institute of Chartered Accountants of Pakistan

Advanced accounting and financial reporting

6 SALE AND LEASEBACK TRANSACTIONS

Section overview

 Sale and leaseback transactions

 Assessing whether the transfer of the asset is a sale
 Sales and lease back – short-term lease or low value asset exemption

6.1 Sale and leaseback transactions

Sale and leaseback transactions involve one entity selling (seller – lessee) an asset to another
entity (buyer – lessor) and then immediately leasing it back. Therefore, in substance it is purely a
financing transaction. The main purpose is to allow the entity to release cash that is ‘tied up’ in the
asset, while retaining right-of-use the asset.
For example, a company may own an office building that it uses for its administrative operations.
It may decide to sell and lease back the building, to raise cash. By selling the building, it raises
cash. By leasing back, the building, it retains the right-of-use of the building for its operational
activities.
Sale and leaseback transactions occur in a number of situations and are economically attractive
for seller-lessees as they can be used:
(a) To obtain financing i-e. generating cash flows.
(b) Result in less financing reflected on the balance sheet than under a traditional mortgage
(c) To reduce exposure to the risks of owning an asset
While, buyer-lessor is usually a financial institution and seller-lessee are Builders (REITs) and
Aviation industry.

6.2 Assessing whether the transfer of the asset is a sale

To determine how to account for a sale-and-leaseback transaction, a company first considers
whether the initial transfer of the underlying asset from the seller-lessee to the buyer-lessor is a
sale. The company applies IFRS 15 to determine whether a sale has taken place.

6.2.1 Transfer of the asset is a sale

a) Seller-Lessee
If the transfer of an asset by the seller-lessee satisfies the requirements of IFRS 15 to be
accounted for as a sale of the asset the seller-lessee shall:
– derecognise the carrying value of the asset
– recognise the sale at fair value
– recognise only the gain/loss that relates to the rights transferred to buyer-lessor.
– recognise a right-of-use asset as proportion of previous carrying amount of underlying
asset retained by the seller-lessee
– recognise a lease liability by PV of lease payments

Example: Sale and leaseback

A company sold a machine for Rs.1.5 million which is also fair value and leased it back under a
five-year lease. The asset has a carrying value of Rs.1 million. The lease payments made by the
lessee is Rs.200,000 p.a paid at the end of the year. The interest rate implicit in the lease is 5%
p.a. Assume that the transfer of machine by the seller-lessee satisfies the requirements of IFRS
15 to be accounted for as a sale

© Emile Woolf International 380 The Institute of Chartered Accountants of Pakistan

 Chapter 17: IFRS 16: Leases

Solution:
Accounting from perspective of Seller-lessee
The PV of lease payments is computed by the following formula:
PV = R[1-(1+i)^-n] /i
R = Yearly payment; i = rate per annum; n = number of years
PV = 200,000x[1-(1+5%)^-5}/5%
PV of payments for the 5 years right of use = Rs.865,895
Right-of-use => 1,000,000(CV) x 865,895 (NPV) /1,500,000 (FV) = Rs.577,263
Gain=500,000 (Total gain which equals to FV–CV)x[1,500,000(FV)–865,895(PV)] /1,500,000 (FV)]
= Rs.211,368

Debit Credit
Rs. Rs.
Cash 1,500,000
Rightof-use 577,263
Asset 1,000,000
Liability - PV of lease payment 865,895
Gain 211,368

Sale proceeds above or below fair value:

If the fair value of the consideration for the sale of an asset:
 does not equal the fair value of the asset, or
 if the payments for the lease are not at market rates, an
 entity shall make the following adjustments to measure the sale proceeds at fair value:
(a) any below-market terms shall be accounted for as a prepayment of lease payments;
and
(b) any above-market terms shall be accounted for as additional financing provided by
the buyer-lessor to the seller-lessee.
The entity shall measure any potential adjustment required in above para on the basis of
the more readily determinable of:
(a) the difference between the sale proceeds and the fair value of the asset; and
(b) the difference between the present value of the lease payments at interest rate implicit
in the lease and the present value of lease payments at market rates.
The entity shall measure any potential adjustment required in above para on the basis of the more
readily determinable of:
(a) the difference between the sale proceeds and the fair value of the asset; and
(b) the difference between the present value of the lease payments at interest rate implicit in
the lease and the present value of lease payments at market rates.

Example: Sale and leaseback – Sale above fair value

A company sold an asset for Rs.1.5 million and leased it back under a five-year lease. The asset
had a carrying value of Rs.1 million. The fair value of the asset at the date of sale is Rs.1.2 million.
The lease payments made by the lessee is Rs.100,000 p.a paid at the end of the year. The interest
rate implicit in the lease is 5% p.a. Assume that the transfer of asset by the seller-lessee satisfies
the requirements of IFRS 15 to be accounted for as a sale.

© Emile Woolf International 381 The Institute of Chartered Accountants of Pakistan

Advanced accounting and financial reporting

Solution:
The PV of lease payments is computed by the following formula:
PV = R[1-(1+i)^-n] /i
R = Yearly payment; i = rate per annum; n = number of years
PV = 100,000x[1-(1+5%)^-5}/5%
PV of Lease payments = Rs.432,947
Adjustment to measure the sale proceeds at fair value (SP-FV) = (Rs.300,000)
PV of payments for the 5 years right of use = Rs.132,947
Right-of-use => 1,000,000(CV) x 132,947(NPV) /1,200,000 (FV) = Rs.110,789
Gain:200,000(Total gain: FV–CV)x(1,200,000–132,947)/1,200,000}=Rs.177,842

Debit Credit

Rs. Rs.

Cash 1,500,000

Right-of-use 110,789

Asset 1,000,000

Lease Liability (PV of Lease Payments) 432,947

Gain 177,842

Atlas Ltd. sells its manufacturing equipment at a price of Rs.5,500,000 to Hybrid Leasing Co.
(buyer-lessor). The fair value of the equipment at time of sale is Rs.6,000,000 and the carrying
value is Rs.3,000,000. The seller-lessee leases back the equipment for 10 years in exchange for
annual rent payments of Rs.400,000 payable at the end of each year. The seller-lessee’s
incremental borrowing rate is 6%. Assume that the transfer of equipment by the seller-lessee
satisfies the requirements of IFRS 15 to be accounted for as a sale.
Solution:
The seller-lessee sold the underlying asset for Rs.5.5 million, which is less than its fair value of
Rs.6 million. The seller-lessee should account for the difference of Rs.0.5 million as prepayment
of lease payments.
The PV of lease payments is computed by the following formula:
PV = R[1-(1+i)^-n] /i
R = Yearly payment; i = rate per annum; n = number of years
PV = 400,000x[1-(1+6%)^-10/ 6%
PV of Lease payments = Rs.2,944,034
Adjustment to measure the sale proceeds at fair value = Rs.500,000
PV of payments for the 10 years right of use = Rs.3,444,034
Right-of-use=> 3,000,000 x 3,444,034 / 6,000,000 = Rs.1,722,017
Gain: 3,000,000 (FV–CV)x(6,000,000–3,444,034)/6,000,000} = Rs.1,277,983

© Emile Woolf International 382 The Institute of Chartered Accountants of Pakistan

 Chapter 17: IFRS 16: Leases

Example: Sale and leaseback – Sale above fair value (continued)

Debit Credit
Rs. Rs.
Cash 5,500,000
Right-of-use asset 1,722,017
Equipment 3,000,000
Lease Liability (PV of Lease payments) 2,944,034
Gain 1,277,983

b) Buyer-Lessor
If the transfer of an asset by the seller-lessee satisfies the requirements of IFRS 15 to be
accounted for as a sale of the asset the buyer-lessor shall account for the purchase of the asset
applying IAS 16, and for the lease applying the lessor accounting requirements for operating
lease in accordance with IFRS 16. In case where the transfer is accounted for as sale, the risks
and rewards are transferred to the buyer-lessor; therefore the lease will always be accounted
for as operating lease in the books of lessor.
The fair value of the asset may differ from the sale proceeds. In such a case the actual fair
value of the asset will be accounted for in accordance with the model selected in accordance
with IAS 16. If cost model is used the fair value will not have any impact and if the fair valuation
model is used than the asset will be recognized at fair value in accordance with IAS 16.

Example: Sale and leaseback

A company sold a machine for Rs.1.5 million and leased it back under a four year lease. The asset
has a carrying value of Rs.1 million. The lease payments made by the lessee is Rs.200,000 p.a
paid at the end of the year. The useful life is 4 years and economic life of an asset is 8 years. The
interest rate implicit in the lease is 5% p.a. Assume that the transfer of machine by the seller-
lessee satisfies the requirements of IFRS 15 to be accounted for as a sale.
Solution:
Accounting from perspective of Buyer-Lessor
The asset is recognized as per IAS 16:
Debit Credit
Rs. Rs.
Property, plant and equipment 1,500,000
Cash 1,500,000
Subsequently after end of each year:
- Asset will be depreciated over the remaining economic life in accordance with IAS 16.
- The operating lease payments will be recognized as income over the lease term.
Rental income accounting entry when the seller lessee makes payment of Rs.200,000 p.a
over the lease term of the asset on a straight line basis
Debit Credit
Rs. Rs.
Cash Rs.200,000
Income Rs.200,000
Accounting entry when the asset remains with the buyer-lessor (idle) after the useful life till the
economic life of an asset for each year:
Depreciation expense Rs.125,000
Accumulated depreciation Rs.125,000

© Emile Woolf International 383 The Institute of Chartered Accountants of Pakistan

Advanced accounting and financial reporting

6.2.2 Transfer of the asset is not a sale

a) Seller-lessee
If the transfer of an asset by the seller-lessee does not satisfy the requirements of IFRS 15 to
be accounted for as a sale of the asset, the seller-lessee shall:
– continue to recognise the transferred asset, and
– shall recognise a financial liability equal to the transfer proceeds applying IFRS 9.

Example: Sale and leaseback – Transfer of asset is not a sale

A company sold a machine for Rs.1.5 million which is also fair value and leased it back under a
five-year lease. The asset has a carrying value of Rs.1 million. The lease payments made by the
lessee is Rs.346,462 p.a paid at the end of the year. The buyer-lessor interest rate implicit in the
lease is 5% p.a. The machine has a remaining economic life of 6 years. A lessor determines that
the machine is of such a specialize nature that only the lessee can use it without major
modification. Lessee has the right to purchase the machine at Rs.50,000 at the end of the lease
term. Initial direct costs are ignored.
Solution:
Accounting in the books of seller-lessee
The seller-lessee will account for lease as a financial liability:
Debit Credit
Rs. Rs.
Cash 1,500,000
Financial liability 1,500,000

b) Buyer Lessor
If the transfer of an asset by the seller-lessee does not satisfy the requirements of IFRS 15 to
be accounted for as a sale of the asset the buyer-lessor shall not recognise the transferred
asset and shall recognise a financial asset equal to the transfer proceeds applying IFRS 9.

Example: Sale and leaseback – Transfer of asset is not a sale

A company sold a machine for Rs.1.5 million which is also fair value and leased it back under a
five-year lease. The asset has a carrying value of Rs.1 million. The lease payments made by the
lessee is Rs.346,462 p.a paid at the end of the year. The buyer-lessor interest rate implicit in the
lease is 5% p.a. The machine has a remaining economic life of 6 years. A lessor determines that
the machine is of such a specialize nature that only the lessee can use it without major
modification. Lessee has a right purchase the machine at Rs.50,000 at the end of the lease term.
Initial direct costs are ignored.
Solution:
Accounting in the books of buyer lessor
The transfer of asset is not a sale as the asset is used by the seller-lessee for the substantial portion
of its useful life and the asset is of specialized nature and can only be used by seller-lessee without
major modification.
The buyer-lessor shall account for lease as a financial asset (in accordance with IFRS 9):

Debit Credit
Rs. Rs.

Financial asset 1,500,000

Cash 1,500,000

© Emile Woolf International 384 The Institute of Chartered Accountants of Pakistan

 Chapter 17: IFRS 16: Leases

Example: (contined)

Subsequently:
At the end of year 1, the interest income and financial asset will be credited as follows:

Debit Credit
Rs. Rs.
Cash 346,462
Financial asset 271,462
Interest receivable 75,000
Lease amortisation schedule will need to be made to account for Principal (Financial asset) and
interest (income) over the useful life of a machine.

6.3 Sales and lease back – short-term lease or low value asset exemption
If a lessee elects not to apply the requirements of a normal lease over a year to either a short-term
lease or lease for which the underlying asset is of low value then the lessee shall recognise the
lease payments associated with those leases as an expense on either a straight-line basis over
the lease term or another systematic basis. The lessee shall apply another systematic basis if that
basis is more representative of the pattern of the lessee’s benefit.
If a lessee accounts for short-term leases applying above paragraph, the lessee shall consider the
lease to be a new lease for the purposes of this Standard if:
(a) there is a lease modification; or
(b) there is any change in the lease term (for example, the lessee exercises an option not
previously included in its determination of the lease term).
The election for short-term leases shall be made by class of underlying asset to which the right of
use relates. A class of underlying asset is a grouping of underlying assets of a similar nature and
use in an entity’s operations. The election for leases for which the underlying asset is of low value
can be made on a lease-by-lease basis this Standard permits a lessee to account for leases for
which the underlying asset is of low value. A lessee shall assess the value of an underlying asset
based on the value of the asset when it is new, regardless of the age of the asset being leased.
The assessment of whether an underlying asset is of low value is performed on an absolute basis.
Leases of low-value assets qualify for the accounting treatment regardless of whether those leases
are material to the lessee. The assessment is not affected by the size, nature or circumstances of
the lessee. Accordingly, different lessees are expected to reach the same conclusions about
whether a particular underlying asset is of low value.
A short term lease is of a period less than a year whereas an underlying asset can be of low value
only 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.
A lease of an underlying asset does not qualify as a lease of a low-value asset if the nature of the
asset is such that, when new, the asset is typically not of low value. For example, leases of cars
would not qualify as leases of low-value assets because a new car would typically not be of low
value.
If a lessee subleases an asset, or expects to sublease an asset, the head lease does not qualify
as a lease of a low-value asset.
Examples of low-value underlying assets can include tablet and personal computers, small items
of office furniture and telephones.

© Emile Woolf International 385 The Institute of Chartered Accountants of Pakistan

Advanced accounting and financial reporting

Example: Sale and leaseback – Sales at Fair Value (Short term lease)
A company sold the furniture for Rs.200,000 and leased it back under a ten months lease at
Rs.4,000 per month
The asset had a carrying value of Rs.160,000 and fair value of Rs.200,000.

Debit Credit

Rs. Rs.

Cash 200,000

Asset – Computer (CV) 160,000

Gain 40,000

When the lessee make payment to lessor over ten month, the lessee shall account for the
payments in equal installments (straight line basis). The following entry will take place;

Debit Credit

Rs. Rs.

Expense 4,000

Cash 4,000

This entry is made for ten accounting periods

Example: Sale and leaseback – Sales above Fair Value (Short term lease)
A company sold the furniture for Rs.200,000 and leased it back under a ten months lease at
Rs.4,000 per month.
The asset had a carrying value of Rs.160,000 and fair value of Rs.180,000.

Debit Credit

Rs. Rs.

Cash 200,000

Asset – Computer (CV) 160,000

Gain 40,000

When the lessee makes payments to lessor over ten months, the lessee shall account for the
payments in equal installments (straight line basis). The following entry will take place;

Debit Credit

Rs. Rs.

Expense 1,000

Cash 1,000

This entry is made for ten accounting periods by the lessee

© Emile Woolf International 386 The Institute of Chartered Accountants of Pakistan

 Chapter 17: IFRS 16: Leases

Example: Sale and leaseback – Sale below fair value (Low value asset)
 A company sold a computer for Rs.35,000 and leased it back under a ten months lease at Rs.1,000
per month The asset had a carrying value of Rs.40,000. The fair value of the asset was Rs.45,000.

Debit Credit

Rs. Rs.

Cash 35,000

Asset 40,000

Statement of comprehensive income 5,000

When the lessee makes payments to lessor over ten months, the lessee shall account for the
payments in equal installments (straight line basis). The following entry will take place;

Debit Credit

Rs. Rs.

Expense 1,000

Cash 1,000

This entry is made for ten accounting periods by the lessee

© Emile Woolf International 387 The Institute of Chartered Accountants of Pakistan

Advanced accounting and financial reporting

7 SUBLEASES
Section overview

 Classification
 Presentation

7.1 Classification
IFRS 16 requires an intermediate lessor to account for
 a head lease, and
 a sublease,
as two separate contracts, applying both the lessee and lessor accounting requirements. This
approach is considered to be appropriate because, in general each contract is negotiated
separately, with the counterparty to the sublease being a different entity from the counterparty to
the head lease.
Accordingly, for an intermediate lessor, the obligations that arise from the head lease are generally
not extinguished by the terms and conditions of the sublease.
In classifying a sublease, an intermediate lessor should classify the sublease as a finance lease
or an operating lease as follows:
 if the head lease is a short-term lease that the entity, as a lessee, has accounted for applying
IFRS 16, the sublease should be classified as an operating lease;
 otherwise, the sublease should be classified by reference to the right-of-use asset arising
from the head lease, rather than by reference to the underlying asset (e.g. the item of
property, plant and equipment that is the subject of the lease).
In classifying a sublease by reference to the right-of-use asset arising from the head lease, an
intermediate lessor will classify more subleases as finance leases than it would have done if those
same subleases were classified by reference to the underlying asset.
The intermediate lessor only has a right to use the underlying asset for a period of time. If the
sublease is for all of the remaining term of the head lease, the intermediate lessor has in effect
transferred that right to another party.
The following examples, reproduced from the illustrative examples accompanying IFRS 16,
illustrate the application of the requirements in IFRS 16 for an intermediate lessor that enters into
a head lease and a sublease of the same underlying asset.

Example 7.1.1: Sublease classified as a finance lease

[IFRS 16: Illustrative example 20]
Head lease – An intermediate lessor enters into a five-year lease of office for 5,000 square metres
of office space (the head lease) with Entity A (the head lessor).
Sublease – At the beginning of Year 3, the intermediate lessor subleases the 5,000 square metres
of office space for the remaining three years of the head lease to a sub-lessee.
The intermediate lessor classifies the sublease by reference to the right-of-use asset arising from
the head lease. The intermediate lessor classifies the sublease as a finance lease.
When the intermediate lessor enters into the sublease, the intermediate lessor:
a) derecognises the right-of-use asset relating to the head lease that it transfers to the sub-lessee
and recognises the net investment in the sublease;
b) recognises any difference between the right-of-use asset and the net investment in the
sublease in profit or loss; and
c) retains the lease liability relating to the head lease in its statement of financial position, which
represents the lease payments owed to the head lessor.
During the term of the sublease, the intermediate lessor recognises both finance income on the
sublease and interest expense on the head lease.

© Emile Woolf International 388 The Institute of Chartered Accountants of Pakistan

 Chapter 17: IFRS 16: Leases

Example 7.1.2: Sublease classified as an operating lease

[IFRS 16: Illustrative example 21]
Head lease – An intermediate lessor enters into a five-year lease for 5,000 square metres of office
space (the head lease) with Entity A (the head lessor).
Sublease – At commencement of the head lease, the intermediate lessor subleases the 5,000
square metres of office space for two years to a sub-lessee.
The intermediate lessor classifies the sublease by reference to the right-of-use asset arising from
the head lease. The intermediate lessor classifies the sublease as an operating lease
When the intermediate lessor enters into the sublease, the intermediate lessor retains the lease
liability and the right-of-use asset relating to the head lease in its statement of financial position.
During the term of the sublease, the intermediate lessor:
a) recognises a depreciation charge for the right-of-use asset and interest on the lease liability;
and
a) recognises lease income from the sublease.

7.2 Presentation
IFRS 16 does not include requirements relating to the presentation of subleases. The IASB decided
that specific requirements were not warranted because there is sufficient guidance in other
Standards. In particular, applying the requirements for offsetting in IAS 1 Presentation of Financial
Statements, an intermediate lessor should not offset assets and liabilities arising from a head lease
and a sublease of the same underlying asset, unless the financial instruments requirements for
offsetting are met.

© Emile Woolf International 389 The Institute of Chartered Accountants of Pakistan

Advanced accounting and financial reporting

SOLUTIONS TO PRACTICE QUESTIONS

Solution 1
The lease is a finance lease.
Reasons
The lease is for a major part of the life of the asset (6 out of 7 years).
Jhang Construction must ensure the asset. It is exposed to one of the major risks of
ownership of the asset (its loss).
The present value of the lease payments is 95.3%
(4.767  600,000/3,000,000) of the fair value of the asset at the inception of the lease.

© Emile Woolf International 390 The Institute of Chartered Accountants of Pakistan

 Certified Finance and Accounting Professional

18

CHAPTER
Advanced accounting and financial reporting

IAS 12: Income taxes

Contents
1 Accounting for taxation
2 Deferred tax: Introduction
3 Recognition of deferred tax: basic approach
4 Recognition and measurement rules
5 Deferred tax: business combinations
6 Presentation and disclosure

© Emile Woolf International 391 The Institute of Chartered Accountants of Pakistan

Advanced accounting and financial reporting

1 ACCOUNTING FOR TAXATION

Section overview

 Taxation of profits
 Over-estimate or under-estimate of tax from the previous year
 Taxation in the statement of financial position

1.1 Taxation of profits

Companies pay income tax on their taxable profits. The tax charge is based on their accounting
profit as adjusted according to the income tax law of Pakistan.

Definitions
Accounting profit is profit or loss for a period before deducting tax expense.
Taxable profit (tax loss) is the profit (loss) for a period, determined in accordance with the rules
established by the taxation authorities, upon which income taxes are payable (recoverable).
Current tax is the amount of income taxes payable (recoverable) in respect of the taxable profit (tax
loss) for a period.

Tax computation
A series of adjustments is made against a company’s accounting profit to arrive at its taxable profit.
These adjustments involve:
 Adding back inadmissible deductions (accounting expenses which are not allowed as a
deduction against taxable profit e.g. accounting depreciation, provision for bad debts etc.)).
 Deducting admissible deductions which include:
 expenses that are allowable as a deduction against taxable profit but which have not
been recognised in the financial statements (e.g. research cost); and
 income recognised in the financial statements but which is exempted from company
income tax (e.g. accrued interest income).
The tax rate is applied to the taxable profit to calculate how much a company owes in tax for the
period. IFRS describes this as current tax.
An exam question might require you to perform a basic taxation computation from information given
in the question.

Illustration: Tax computation format

Rs.
Accounting profit before tax X
Add back: Inadmissible deductions X
Less: Admissible deductions (X)

Taxable profit X
Tax rate x%

Tax payable (current tax) X

© Emile Woolf International 392 The Institute of Chartered Accountants of Pakistan

 Chapter 18: IAS 12: Income taxes

Example: Taxation computation

X Limited had an accounting profit of Rs. 789,000 for the year ended 31 December 2016.
The accounting profit was after depreciation of Rs. 70,000 and included a profit on disposal (capital
gain) of Rs. 97,000.
The company had incurred borrowing costs of Rs. 70,000 in the year of which Rs. 10,000 had been
capitalised in accordance with IAS 23.
The company holds some assets under finance leases. During the year finance charge in respect
of the leases was Rs. 15,000 and rentals paid were Rs. 80,000.
At 1 January 2016 the tax written down value of machinery was Rs. 120,000 and for buildings was
Rs. 600,000.
Tax regime
All borrowing costs are deductible for tax purposes.
Capital gains are not taxable.
Fines are not tax deductible.
Finance lease rentals are deductible in full for tax purposes.
Accounting depreciation is not allowable for tax purposes.
Tax depreciation is claimable at 10% per annum for buildings and 15% per annum for machinery
applied to tax written down value at the start of the year.
Tax is paid at 30%
The tax computation is as follows:

Rs.
Accounting profit 789,000
Add back inadmissible deductions:
Accounting depreciation 70,000
Fine paid 125,000
Finance charge on finance lease 15,000
210,000
Less: Admissible deductions
Lease payments 80,000
Capital gain 97,000
Borrowing cost capitalised 10,000
(187,000)
Assessable profit 812,000
Less: Capital allowances
(15%  120,000 + 10%  600,000) (78,000)
Taxable profit 734,000
Income tax (30% of taxable profit) 220,200

© Emile Woolf International 393 The Institute of Chartered Accountants of Pakistan

Advanced accounting and financial reporting

Tax base
The above example referred to the tax written down value of the machinery and buildings. This is
the tax authority’s view of the carrying amount of the asset measured at cost less capital
allowances calculated according to the tax legislation.
IFRS uses the term tax base to refer to an asset or liability measured according to the tax rules.

Definition
The tax base of an asset or liability is the amount attributed to that asset or liability for tax purposes.

The tax base of an asset is the amount that the tax authorities will allow as a deduction in the future
against any taxable profits that will flow to an entity when it recovers the carrying amount of the
asset.
Measurement
Current tax liabilities (assets) for the current and prior periods must be measured at the amount
expected to be paid to (recovered from) the taxation authorities, using the tax rates (and tax laws)
that have been enacted or substantively enacted by the end of the reporting period.

1.2 Over-estimate or under-estimate of tax from the previous year

Current tax for current and prior periods must be recognised as a liability until paid. If the amount
already paid exceeds the amount due the excess must be recognised as an asset.
When the financial statements are prepared, the tax charge on the profits for the year is likely to
be an estimate. The figure for tax on profits in the statement of comprehensive income is therefore
not the amount of tax that will eventually be payable, because it is only an estimate. The actual tax
charge, agreed with the tax authorities some time later, is likely to be different.
In these circumstances, the tax charge for the year is adjusted for any under-estimate or over-
estimate of tax in the previous year.
 an under-estimate of tax on the previous year’s profits is added to the tax charge for the
current year.
 an over-estimate of tax on the previous year’s profits is deducted from the tax charge for the
current year.

Example: Over-estimate or under-estimate of tax

Rs. Rs.
Profit from operations 460,000
Interest (60,000)
Profit before tax 400,000
Tax:
Adjustment for under-estimate of tax in the previous
year 3,000
Tax on current year profits 100,000
Tax charge for the year (103,000)
Profit after tax 297,000

1.3 Taxation in the statement of financial position

The taxation charge for the year is the liability that the company expects to pay. The timing of tax
payments on profits varies from one country to another, depending on the tax rules in each country.
The actual amount of tax payable, and reported in the statement of financial position as a current
liability (taxation payable), is calculated as follows:

© Emile Woolf International 394 The Institute of Chartered Accountants of Pakistan

 Chapter 18: IAS 12: Income taxes

Illustration: Taxation in the statement of financial position

Rs.
Tax payable at the beginning of the year X
Tax charge for the year X
X
Tax payments made during the year (X)
Tax payable at the end of the year X

Example: Taxation in the financial statements

Fresh Company has a financial year ending on 31 December.
At 31 December 2015 it had a liability for income tax of Rs. 77,000.
The tax on profits for the year to 31 December 2016 was Rs. 114,000.
The tax charge for the year to 31 December 2015 was over-estimated by Rs. 6,000.
During the year to 31 December 2016, the company made payments of Rs. 123,000 in income
tax.
This would result in the following accounting treatment:
Tax charge in the statement of comprehensive income Rs.
Tax on current year profits 114,000
Adjustment for over-estimate of tax in the previous year (6,000)
Taxation charge for the year 108,000

Tax liability in the statement of financial position Rs.

Tax payable at the beginning of the year 77,000
Tax charge for the year 108,000
185,000
Tax payments made during the year (123,000)
Tax payable at the end of the year 62,000

© Emile Woolf International 395 The Institute of Chartered Accountants of Pakistan

Advanced accounting and financial reporting

2 DEFERRED TAX: INTRODUCTION

Section overview

 Deferred taxation – Underlying problem

 Identifying deferred tax balances
 IAS 12 approach to the problem

2.1 Deferred taxation - Underlying problem

Deferred tax is neither deferred, nor tax rather it is an accounting measure, more specifically an
accrual for tax. It is a timing difference between the economic benefits and the taxation.
As explained in the last section, in most jurisdictions the rules for the recognition and measurement
of certain assets, liabilities, income and expenses for tax purposes differ from the equivalent rules
under IFRSs. This results in different figures in the financial statements and in the tax
computations/tax working papers.
It is convenient to envisage two separate sets of accounts:
 one set constructed following IFRS rules; and,
 a second set following the tax rules (tax computations).
This results in a breakdown in the tax rate percentage relationship between the profit before tax
figure and the taxation figure. In other words, the tax charge is not the tax rate applied to the profit
before tax.

Example: Deferred taxation - Underlying problem

X Limited made accounting profit before tax of Rs. 50,000 in each of the years, 20X1, 20X2 and
20X3 and pays tax at 30%.
X Limited bought an item of plant on 1 January 20X1 for Rs. 9,000. This asset is to be depreciated
on a straight line basis over 3 years.
Accounting depreciation is not allowed as a taxable deduction in the jurisdiction in which the
company operates. Instead tax allowable depreciation is available as shown in the following tax
computations.
20X1 20X2 20X3
Rs. Rs. Rs.
Accounting profit (after depreciation) 50,000 50,000 50,000
Add back depreciation 3,000 3,000 3,000
Deduct capital allowances (4,500) (2,500) (2,000)
(1,500) 500 1,000
Taxable profit 48,500 50,500 51,000
Tax @ 30% 14,550 15,150 15,300

In the absence of the recognition of deferred tax this would be reported as follows:

X Limited: Statement of comprehensive income for the years ending:

20X1 20X2 20X3 Total
Rs. Rs. Rs. Rs.
Profit before tax 50,000 50,000 50,000 150,000
Income tax @ 30% (as above) (14,550) (15,150) (15,300) (45,000)
Profit after tax 35,450 34,850 34,700 105,000

© Emile Woolf International 396 The Institute of Chartered Accountants of Pakistan

 Chapter 18: IAS 12: Income taxes

Example: Deferred taxation - Underlying problem (continued)

Looking at the total column, the profit before tax is linked to the taxation figure through the tax rate
(150,000  30% = 45,000).
This is not the case in each separate year.
This is because the current tax charge is not found by multiplying the accounting profit before tax
by the tax rate. Rather, it is found by multiplying an adjusted version of this figure by the tax rate
The item of plant is written off in the calculation of both accounting profit and taxable profit but by
different amounts in different periods. The differences are temporary in nature as over the three
years period, the same expense is recognised for the item of plant under both the accounting rules
and the tax rules.

Transactions recognised in the financial statements in one period may have their tax effect deferred
to (or more rarely, accelerated from) another. Thus the tax is not matched with the underlying
transaction that has given rise to it.
In the above example the tax consequences of an expense (depreciation in this case) are
recognised in different periods to when the expense is recognised.
Accounting for deferred tax is based on the principle that the tax consequence of an item should
be recognised in the same period as the item is recognised. It tries to match tax expenses and
credits to the period in which the underlying transactions to which they relate are recognised.
In order to do this, the taxation effect that arises due to the differences between the figures
recognised under IFRS and the tax rules is recognised in the financial statements.
The double entry to achieve this is between a deferred tax balance in the statement of financial
position (which might be an asset or a liability) and the tax charge in the statement of
comprehensive income.
The result of this is that the overall tax expense recognised in the statement of comprehensive
income is made up of the current tax and deferred tax numbers.

Definition: Tax expense

Tax expense (tax income) is the aggregate amount included in the determination of profit or loss
for the period in respect of current tax and deferred tax.

2.2 Identifying deferred tax balances

The differences between the two sets of rules will result in different numbers in the financial
statements and in the tax computations.
Two perspectives
These differences can be viewed from:
 a statement of comprehensive income (income and expenses) perspective:
 the differences arising in the period are identified by comparing income and expenses
recognised under IFRS to the equivalent figures that are taxable or allowable under
tax legislation;
 the approach identifies the deferred tax expense or credit recognised in the statement
of comprehensive income for the period (with the other side of the entry recognised
as a liability or asset);or
 a statement of financial position (assets and liabilities) perspective:
 the differences are identified on a cumulative basis by comparing the carrying amount
of assets and liabilities under IFRS to the carrying amount of the same assets and
liabilities according to the tax rules;
 the approach identifies the deferred tax liability (or asset) that should be recognised
(with the movement on this amount recognised as a credit or expense in the statement
of comprehensive income).

© Emile Woolf International 397 The Institute of Chartered Accountants of Pakistan

Advanced accounting and financial reporting

IAS 12 uses the statement of financial position perspective but both will be explained here for
greater understanding.

Example: Two perspectives

The following table identifies the differences between the accounting treatment and the taxation
treatment of the item of plant from both perspectives.

Assets
Carrying and Income and
amount Tax base liabilities expenses
Cost at 01/01/X1 9,000 9,000
Charge for the year (3,000) (4,500) (1,500)
Cost at 31/12/X1 6,000 4,500 1,500
Charge for the year (3,000) (2,500) 500
Cost at 31/12/X21 3,000 2,000 1,000
Charge for the year (3,000) (2,000) 1,000
Cost at 31/12/X3    

Statement of comprehensive income perspective

Example: Statement of comprehensive income perspective

20X1:
Rs. 3,000 is disallowed but Rs. 4,500 is allowed instead.
 taxable expense is Rs. 1,500 greater than the accounting expense.
taxable profit is Rs. 1,500 less than accounting profit.
 current tax is reduced by 30% of Rs. 1,500 (Rs. 450).
 deferred tax expense of Rs. 450 must be recognised to restore the balance
(Dr: Tax expense / Cr: Deferred taxation liability).

20X2:
Rs. 3,000 is disallowed but Rs. 2,500 is allowed instead.
 taxable expense is Rs. 500 less than the accounting expense.
taxable profit is Rs. 500 more than accounting profit.
 current tax is increased by 30% of Rs. 500 (Rs. 150).
 deferred tax credit of Rs. 150 must be recognised to restore the balance
(Dr: Deferred taxation liability / Cr: Tax expense).

20X3:
Rs. 3,000 is disallowed but Rs. 2,000 is allowed instead.
 taxable expense is Rs. 1,000 less than the accounting expense.
taxable profit is Rs. 1,000 more than accounting profit.
 current tax is increased by 30% of Rs. 1,000 (Rs. 300).
 deferred tax credit of Rs. 300 must be recognised to restore the balance
(Dr: Deferred taxation liability / Cr: Tax expense).

© Emile Woolf International 398 The Institute of Chartered Accountants of Pakistan

 Chapter 18: IAS 12: Income taxes

The statement of comprehensive income would now be as follows:

20X1 20X2 20X3
Rs. Rs. Rs.
Profit before tax 50,000 50,000 50,000
Income tax @ 30% W1 14,550 15,150 15,300
Deferred tax 450 (150) (300)
(15,000) (15,000) (15,000)
Profit after tax 35,000 35,000 35,000

Statement of financial position

Deferred tax liability:
Balance b/f nil 450 300
Movement in the year 450 (150) (300)
Balance b/f 450 300 nil

Statement of financial position perspective

Example continued: Statement of financial position perspective

This approach compares the carrying amount of assets and liabilities in the financial statements
to their tax base to identify the cumulative differences to that point in time.
These differences are called temporary differences.
An asset in the financial statements compared to the taxman’s view requires the recognition of a
deferred tax liability which is measured by applying the tax rate to the temporary difference.

Carrying Temporary Tax @

amount Tax base difference 30%
At 31/12/X1 6,000 4,500 1,500 450
At 31/12/X2 3,000 2,000 1,000 300
At 31/12/X3 nil nil nil nil

By the end of 20X1

The asset in the financial statements is Rs. 1,500 more than the tax base.
A deferred tax liability of Rs. 450 must be recognised.

Debit Credit
Tax expense 450
Deferred tax liability 450

By the end of 20X2

The asset in the financial statements is Rs. 1,000 more than the tax base.
A deferred tax liability of Rs. 300 must be recognised but there was Rs. 450 at the start of the
year so the liability must be reduced.

Debit Credit
Deferred tax liability 150
Tax expense 150

© Emile Woolf International 399 The Institute of Chartered Accountants of Pakistan

Advanced accounting and financial reporting

By the end of 20X3

The asset in the financial statements is the same as the tax base (nil).
A deferred tax liability of nil must be recognised but there was Rs. 300 at the start of the year
so the liability must be reduced.

Debit Credit
Deferred tax liability 300
Tax expense 300

These amounts are the same as on the previous page and would have the same
impact on the financial statements.

The recognition of deferred taxation has restored the relationship between profit before tax and the
tax charge through the tax rate in each year (30% of Rs. 50,000 = Rs. 15,000).
Terminology
When a difference comes into existence or grows it is said to originate. When the difference
reduces in size it is said to reverse.
Thus, in the above example a difference of Rs. 1,500 originated in 20X1. This difference then
reversed in 20X2 and 20X3.

2.3 IAS 12 approach to the problem

IAS 12: Income taxes, advocates a statement of financial position approach.
Business must identify a deferred tax liability (or perhaps asset) at each reporting date.
It must do this by identifying the differences between the carrying amount of assets and liabilities
in the financial statements to the tax base (tax authority’s view of those same items). These
differences are known as temporary differences (this will be explained in more detail in the next
section).
Once the temporary differences have been identified the deferred tax balance is calculated by
applying the appropriate tax rate to the difference.

© Emile Woolf International 400 The Institute of Chartered Accountants of Pakistan

 Chapter 18: IAS 12: Income taxes

3 RECOGNITION OF DEFERRED TAX: BASIC APPROACH

Section overview

 Identifying the temporary difference

 Taxable and deductible temporary differences
 Sources of temporary differences
 Accounting for deferred tax
 Deferred tax relating to revaluations and other items recognised outside profit or loss
 SIC 25: Changes in tax status of an entity or its shareholders

3.1 Identifying the temporary difference

Accounting for deferred tax is based on the identification of the temporary differences.

Definition: Temporary difference

Temporary differences are differences between the carrying amount of an asset or liability in the
statement of financial position and its tax base.
Temporary differences may be either:
(a) taxable temporary differences, which are temporary differences that will result in taxable
amounts in determining taxable profit (tax loss) of future periods when the carrying amount
of the asset or liability is recovered or settled; or
(b) deductible temporary differences, which are temporary differences that will result in amounts
that are deductible in determining taxable profit (tax loss) of future periods when the carrying
amount of the asset or liability is recovered or settled.

The tax base of an asset is the amount that will be deductible for tax purposes against any taxable
economic benefit that will flow to an entity when it recovers the carrying amount of the asset.

Definition: Tax base

The tax base of an asset or liability is the amount attributed to that asset or liability for tax purposes.

3.2 Taxable and deductible temporary differences

Temporary differences may be either taxable temporary differences or deductible temporary
differences.
Taxable temporary differences
A taxable temporary difference is caused by a debit in the carrying amount of an asset or liability
in the financial statements compared to the tax base of that item.
Taxable temporary differences lead to the recognition of deferred tax liabilities.
Example: Taxable temporary differences
Each of the following is a taxable temporary difference leading to the recognition of a deferred tax
liability.
Carrying Temporary Deferred tax
amount Tax base difference liability (30%)
Non-current asset 1,000 800 200 60
Inventory 650 600 50 15
Receivable 800 500 300 90
Receivable (note 1) 500 nil 500 150
Payable (note 2) (1,000) (1,200) 200 60

© Emile Woolf International 401 The Institute of Chartered Accountants of Pakistan

Advanced accounting and financial reporting

Example: Taxable temporary differences (continued)

Note 1:
This implies that an item accounted for using the accruals basis in the financial statements is
being taxed on a cash bases.
If an item is taxed on cash basis the tax base would be zero as no receivable would be recognised
under the tax rules.
Note 2:
The credit balance in the financial statements is Rs. 1,000 and the tax base is a credit of Rs.
1,200. Therefore, the financial statements show a debit balance of 200 compared to the tax
base. This leads to a deferred tax liability.

IAS 12 rationalises the approach as follows (using the non-current assets figures to illustrate)
Inherent in the recognition of an asset is that the carrying amount (Rs. 1,000) will be
recovered in the form of economic benefits that will flow to the entity in future periods.
When the carrying amount exceeds the tax base (as it does in this case at Rs. 800) the amount
of taxable economic benefit will exceed the amount that will be allowed as a deduction for
tax purposes.
This difference is a taxable temporary difference and the obligation to pay the resulting
income tax in the future periods is a liability that exists at the reporting date.
The company will only be able to deduct Rs. 800 in the tax computations against the recovery
of Rs. 1,000.
The Rs. 200 that is not covered will be taxed and that tax should be recognised for now.

Definition: Deferred tax liability

Deferred tax liabilities are the amounts of income taxes payable in future periods in respect of
taxable temporary differences.

Deductible temporary differences

A deductible temporary difference is caused by a credit in the carrying amount of an asset or liability
in the financial statements compared to the tax base of that item.
Deductible temporary differences lead to the recognition of deferred tax assets.

Example: Deductible temporary differences

Each of the following is a deductible temporary difference leading to the recognition of a deferred
tax asset.

Deferred
Carrying Temporary
Tax base tax asset
amount difference
(30%)
Non-current asset (note 1) 1,000 1,200 (200) 60
Receivable 800 900 (100) 30
Payable (1,200) (1,000) (200) 60

Note 1:
There is a debit balance for the non-current asset of Rs. 1,000 and its tax base is a
debit of Rs. 1,200. Therefore, the financial statements show a credit balance of 200
compared to the tax base. This leads to a deferred tax asset.

© Emile Woolf International 402 The Institute of Chartered Accountants of Pakistan

 Chapter 18: IAS 12: Income taxes

Definition: Deferred tax asset

Deferred tax assets are the amounts of income taxes recoverable in future periods in respect of:
(a) deductible temporary differences;
(b) the carry forward of unused tax losses; and
(c) the carry forward of unused tax credits.

3.3 Sources of temporary differences

Circumstances under which temporary differences arise include;
 Situations when income or expense is included in accounting profit in one period but included
in the taxable profit in a different period. Examples include:
 items which are taxed on a cash basis but which will be accounted for on an accruals
basis.
 situations where the accounting depreciation does not equal capital allowances.
 Revaluation of assets where the tax authorities do not amend the tax base when the asset
is revalued.
Examples leading to the recognition of deferred tax liabilities
Interest may be received in arrears, leading to a receivable in the statement of financial position.
However, this interest may not be taxable until the cash is received.

Example: Recognition of deferred tax liabilities

A Limited recognises interest receivable of Rs. 600,000 in its financial statements.
No cash has yet been received and interest is taxed on a cash basis. The interest receivable has a
tax base of nil.
Carrying Temporary
amount Tax base difference
Rs. Rs. Rs.
Interest receivable 600,000  600,000
Deferred tax liability @ 30% 180,000

Development costs may be capitalised and amortised (in accordance with IAS 38) but tax relief
may be given for the development costs as they are paid.

Example: Recognition of deferred tax liabilities

In the year ended 30 June 2016, B Limited incurred development costs of Rs. 320,000.
These were capitalised in accordance with IAS 38, with an amortisation charge of Rs. 15,000 in
2016.
Development costs are an allowable expense for tax purposes in the period in which they are paid.
The relevant tax rate is 30%.

Carrying Temporary
amount Tax base difference
Rs. Rs. Rs.
Development costs 305,000  305,000
Deferred tax liability @ 30% 91,500

© Emile Woolf International 403 The Institute of Chartered Accountants of Pakistan

Advanced accounting and financial reporting

Accounting depreciation is not deductible for tax purposes in most tax regimes. Instead the
governments allow a deduction on statutory grounds.

Example: Recognition of deferred tax liabilities

C Limited has non-current assets at 31 December 2016 with a cost of Rs. 5,000,000.
Accumulated depreciation for accounting purposes is Rs. 2,250,000 to give a carrying amount of
Rs. 2,750,000
Tax deductible depreciation of Rs. 3,000,000 has been deducted to date.
The fixed assets have a tax base of Rs. 2,000,000.
Carrying Temporary
amount Tax base difference
Rs. Rs. Rs.
Non-current asset 2,750,000 2,000,000 750,000
Deferred tax liability @ 30% 225,000

Examples leading to the recognition of deferred tax assets

Certain assets may be carried at fair value or may be revalued, without an equivalent adjustment
being made for tax purposes. A deductible temporary difference arises if the tax base of the asset
exceeds its carrying amount.
For deferred tax asset related to debt instrument measured at fair value, please review illustrative
example after paragraph 26(d) of IAS 12
When an entity assesses whether taxable profits will be available against which it can utilise a
deductible temporary difference, it considers whether tax law restricts the sources of taxable profits
against which it may make deductions on the reversal of that deductible temporary difference. If
tax law imposes no such restrictions, an entity assesses a deductible temporary difference in
combination with all of its other deductible temporary differences. However, if tax law restricts the
utilisation of losses to deduction against income of a specific type, a deductible temporary
difference is assessed in combination only with other deductible temporary differences of the
appropriate type.
When there are insufficient taxable temporary differences relating to the same taxation authority
and the same taxable entity, the deferred tax asset is recognised to the extent that:
(a) it is probable that the entity will have sufficient taxable profit relating to the same taxation
authority and the same taxable entity in the same period as the reversal of the deductible
temporary difference (or in the periods into which a tax loss arising from the deferred tax
asset can be carried back or forward). In evaluating whether it will have sufficient taxable
profit in future periods, an entity:
(i) compares the deductible temporary differences with future taxable profit that excludes
tax deductions resulting from the reversal of those deductible temporary differences.
This comparison shows the extent to which the future taxable profit is sufficient for the
entity to deduct the amounts resulting from the reversal of those deductible temporary
differences; and
(ii) ignores taxable amounts arising from deductible temporary differences that are
expected to originate in future periods, because the deferred tax asset arising from
these deductible temporary differences will itself require future taxable profit in order to
be utilised; or
(b) tax planning opportunities are available to the entity that will create taxable profit in
appropriate periods.
The estimate of probable future taxable profit may include the recovery of some of an entity’s
assets for more than their carrying amount if there is sufficient evidence that it is probable that the
entity will achieve this. For example, when an asset is measured at fair value, the entity shall
consider whether there is sufficient evidence to conclude that it is probable that the entity will
recover the asset for more than its carrying amount. This may be the case, for example, when an
entity expects to hold a fixed-rate debt instrument and collect the contractual cash flows.

© Emile Woolf International 404 The Institute of Chartered Accountants of Pakistan

 Chapter 18: IAS 12: Income taxes

Warranty costs may be recognised as a liability (in accordance with IAS 37) but tax relief may be
given only when the cash is spent in the future.

Example: Recognition of deferred tax assets

D Limited recognises a liability of Rs. 100,000 for accrued product warranty costs.
For tax purposes, the product warranty costs will not be deductible until the entity pays any warranty
claims. (Therefore the tax base is nil).
The company is very profitable and does not expect this to change. (This means that they expect to
pay tax in the future so should be able to recover the deferred tax asset).

Carrying Temporary
amount Tax base difference
Rs. Rs. Rs.
Warranty provision 100,000  100,000
Deferred tax asset @ 30% 30,000
This time the financial statements contain a liability when compared to the tax authority’s
view of the situation. Therefore deferred tax is an asset.

It is possible to have a temporary difference even if there is no asset or liability. In such cases there
is a zero value for the asset (or liability). For example, research costs may be expensed as incurred
(in accordance with IAS 38) but tax relief may be given for the costs at a later date.

Example: Recognition of deferred tax assets

In the year ended 31 December 2016, E Limited incurred research costs of Rs. 500,000.
These were expensed accordance with IAS 38.
Research costs are not permitted as a taxable deduction until a later period.
The relevant tax rate is 30%.

Carrying Temporary
amount Tax base difference
Rs. Rs. Rs.
Research costs nil 500,000 500,000
Deferred tax asset @ 30% 150,000

As a general rule when

 Income approach
 Accounting income > Taxable income = Deferred tax liability
 Taxable income > Accounting income = Deferred tax asset
 Balance sheet approach
 In case of assets: Carrying amount > Tax base = Deferred tax liability (and vice versa)
 In case of liabilities: Carrying amount > Tax base = Deferred tax asset (and vice versa)

3.4 Accounting for deferred tax

Accounting for deferred taxation involves the recognition of a liability (or an asset) in the statement
of financial position at each year end. The business must then account for the movement on the
liability (or asset).

© Emile Woolf International 405 The Institute of Chartered Accountants of Pakistan

Advanced accounting and financial reporting

The other side of the entry that changes the balance on the deferred taxation liability (asset) is
recognised in the statement of profit or loss except to the extent that it arises in other
comprehensive income or directly in equity.
Approach
The calculation of the balance to be recognised in the statement of financial position is quite
straightforward.
 Step 1: Identify the temporary differences (this should always involve a columnar working
as in the example below);
 Step 2: Multiply the temporary differences by the appropriate tax rate.
 Step 3: Compare this figure to the opening figure and complete the double entry.

Example: Accounting for deferred tax

X Limited has non-current assets with a carrying value of Rs. 200,000 and a tax base of Rs.
140,000.
It has recognised a receivable of Rs. 10,000. This relates to income which is taxed on a cash basis.
It has also accrued for an expense in the amount of Rs. 20,000. Tax relief is only given on this
expense when it is paid.
At the start of the year X Limited had a deferred tax liability of Rs. 12,000.
Required
Show the movement on the deferred tax account and construct the journal to record this
movement.
In order to answer a question like this you need to complete the following proforma:

Rs.
Deferred taxation balance at the start of the year 12,000
Transfer to the income statement (as a balancing figure) ?

Deferred taxation balance at the end of the year (working) ?

In order to complete this you need a working to identify the temporary differences.

The temporary differences are identified and the required deferred tax balance calculated as
follows:

Working:
Carrying Temporary DT balance at
amount Tax base differences 30%
Rs. Rs. Rs. Rs.
Non-current assets 200,000 140,000 60,000 18,000
(liability)
Accrued income 10,000  10,000 3,000
(liability)
Accrued expense (20,000)  (20,000) (6,000)
asset

50,000 15,000

© Emile Woolf International 406 The Institute of Chartered Accountants of Pakistan

 Chapter 18: IAS 12: Income taxes

The answer can then be completed by filling in the missing figures and constructing the journal
as follows:

Rs.
Deferred taxation balance at the start of the year 12,000
Statement of profit or loss (as a balancing figure) 3,000
Deferred taxation balance at the end of the year (working above) 15,000

Journal: Debit Credit

Income statement (tax expense) 3,000
Deferred tax liability 3,000

3.5 Deferred tax relating to revaluations and other items recognised outside profit or
loss
A change in the carrying amount of an asset or liability might be due to a transaction recognised
outside the statement of profit or loss.
For example, IAS 16: Property, plant and equipment, allows for the revaluation of assets. The
revaluation of an asset without a corresponding change to its tax base (which is usually the case)
will change the temporary difference in respect of that asset. An increase in the carrying amount
of an asset due to an upward revaluation is recognised outside profit or loss. In Pakistan it is
credited directly to an account “outside equity” called revalution surplus in accordance with the
Companies Act, 2017. (Elsewhere is credited to other comprehensive income in accordance with
IAS 16).
In these cases, the other side of the entry that changes the balance on the deferred taxation liability
(asset) is also recognised outside the statement of profit or loss and in the same location as the
transaction that gave rise to the change in the temporary difference.

Example continued: Accounting for deferred tax

The following information relates to the movement on the carrying amount of an item of plant
together with temporary differences in a reporting period.

Carrying Temporary DT balance at

amount Tax base differences 30%
Rs. Rs. Rs. Rs.
At 1 January 100,000 80,000 20,000 6,000
Depreciation (10,000) (15,000) 5,000 1,500
90,000 65,000
Revaluation 35,000  35,000 10,500
125,000 65,000 60,000 18,000

The movement on the deferred tax liability is as follows:

Rs.
Deferred taxation balance at the start of the year 6,000
Statement of profit or loss (usually as a balancing figure) 1,500
Revaluation surplus 10,500
Deferred taxation balance at the end of the year (working above) 18,000

© Emile Woolf International 407 The Institute of Chartered Accountants of Pakistan

Advanced accounting and financial reporting

Example continued: Accounting for deferred tax (continued)

Journal: Debit Credit

Statement of profit or loss (tax expense) 1,500

Revaluation surplus 10,500

Deferred tax liability 12,000

Note: The balance on the revaluation surplus account is a credit balance stated net of taxation
at Rs. 24,500 (Rs. 35,000 – Rs. 10,500).

Items recognised outside profit or loss

IFRS requires or permits various items to be recognised in other comprehensive income. Examples
of such items include:
 a change in carrying amount arising from the revaluation of property, plant and equipment
(IAS 16) though this is not the case in Pakistan;
 a change in carrying amount arising from the revaluation of intangible assets (IAS 38:
Intangible assets) though this is not the case in Pakistan;
 remeasurements of defined benefit plans (IAS 19: Employee benefits);
 exchange differences arising on the translation of the financial statements of a foreign
operation (IAS 21: The effects of changes in foreign exchange rates);
IFRS requires or permits various items to be recognised directly in equity. Examples of such items
include:
 adjustment to the opening balance of retained earnings resulting from either a change in
accounting policy that is applied retrospectively or the correction of an error (see IAS 8:
Accounting policies, changes in accounting estimates and errors); and
 amounts arising on initial recognition of the equity component of a compound financial
instrument (IAS 32: Financial Instruments: Presentation).
Deferred tax and convertible bonds
IAS 32: Financial instruments: Presentation requires that on initial recognition of a compound
instrument, for example a convertible bond, the credit entry must be split into the two component
parts, equity and liability.
In many jurisdictions the tax base of the convertible bond would be the amount borrowed.
Therefore, split accounting results in the origination of a taxable temporary difference (being the
difference between the carrying amount of the liability and its tax base).
An entity must recognise the resultant deferred tax liability. The temporary difference arises on
initial recognition because the equity portion of the bond is recognised in equity. Therefore, the
other side of the double entry to establish the deferred tax liability is also recognised in equity
(where it is netted off against the equity component.
Over the life of the bond its carrying value is adjusted to the amount borrowed. Therefore, the
taxable temporary difference and the resultant deferred tax liability falls over the bond’s life. These
changes in the deferred taxation liability are due differences in the annual effective rate used to
value the initial liability and the cash interest. Therefore, the movement in deferred tax is recognised
in the statement of profit or loss.
The following example is a continuation of the example seen in paragraph 1.3 in Chapter 16:
Financial Instruments: Presentation and disclosure.

© Emile Woolf International 408 The Institute of Chartered Accountants of Pakistan

 Chapter 18: IAS 12: Income taxes

Example: Deferred taxation and convertible bonds

A company issues Rs. 10 million of 6% convertible bonds at par on 1 January 20X1.
The bonds are redeemable at par after four years.
The market rate of interest for similar debt which is not convertible is 8%.
The bonds was recorded in the statement of financial position at the date of issue as follows:

Dr Cr
Cash 10,000,000
Liability 9,337,200
Equity (see working) 662,800

Subsequent measurement of the liability would be as follows:

Cash flow
Amortised cost Interest at (interest
at start of the effective rate actually paid Amortised cost
End of: year (8%) at 6%) at year end
20X1 9,337,200 746,976 (600,000) 9,484,176
20X2 9,484,176 758,734 (600,000) 9,642,910
20X3 9,642,910 771,433 (600,000) 9,814,343
20X4 9,814,343 785,557 (600,000) 10,000,000

The deferred tax liability at initial recognition and at each subsequent year end is as calculated as
follows:

Carrying Temporary Deferred tax

amount Tax base difference liability (30%)
Rs. Rs. Rs.
Initial
recognition 9,337,200 10,000,000 (662,800) (198,840)
End of:
20X1 9,484,176 10,000,000 (515,824) (154,747)
20X2 9,642,910 10,000,000 (357,090) (107,127)
20X3 9,814,343 10,000,000 (185,657) (55,697)
20X4 10,000,000 10,000,000 0
Working
Interest paid and Discount factor at Discounted
actual cash outflow market interest rate cash flow
End of: (8%)
20X1 600,000 0.9259 555,540
20X2 600,000 0.8573 514,380
20X3 600,000 0.7938 476,280
20X4 10,600,000 0.7350 7,791,000
Liability 9,337,200
Cash received 10,000,000
Equity 662,800

© Emile Woolf International 409 The Institute of Chartered Accountants of Pakistan

Advanced accounting and financial reporting

The double entries to record the deferred taxation at initial recognition and at each year end are as
follows:
Initial recognition

Dr Cr
Equity 198,840
Deferred tax liability 198,840

Note: The complete double entry to record the convertible bond and deferred tax on initial
recognition is as follows

Cash 10,000,000
Liability 9,337,200
Deferred tax liability 198,840
Equity (662,800 – 198,840) 463,960

Year 1
Deferred tax liability (198,840  154,747) 44,093
Statement of profit and loss 44,093

Year 2
Deferred tax liability (154,747  107,127) 47,620
Statement of profit and loss 47,620

Year 3
Deferred tax liability (107,127  55,697) 51,429
Statement of profit and loss 51,429

Year 4
Deferred tax liability (55,697  0) 55,697
Statement of profit and loss 55,697

3.6 SIC 25: Changes in tax status of an entity or its shareholders

Issue
A change in the tax status of an entity or its shareholders may increase or decrease tax assets and
liabilities.
How should the tax consequences of such change be accounted for?
Consensus
The current and deferred tax consequences of a change in tax status must be included in the
statement of profit or loss for the period unless they relate to transactions recognised in other
comprehensive income or directly in equity.
In those cases the tax consequences should be recognised in other comprehensive income or
directly in equity.

© Emile Woolf International 410 The Institute of Chartered Accountants of Pakistan

 Chapter 18: IAS 12: Income taxes

4 RECOGNITION AND MEASUREMENT RULES

Section overview

 Recognition of deferred tax liabilities

 Recognition of deferred tax assets
 A recognition issue – non-taxable items
 Measurement of deferred tax balances

4.1 Recognition of deferred tax liabilities

A deferred tax liability must be recognised for all taxable temporary differences, except to the extent
that the deferred tax liability arises from:
 the initial recognition of goodwill; or
 the initial recognition of an asset or liability in a transaction which:
 is not a business combination; and
 at the time of the transaction, affects neither accounting profit nor taxable profit (tax
loss).
There is further guidance on the recognition of deferred tax liabilities in respect of taxable
temporary differences arising in a business combination.
Comment on the exceptions: Goodwill
Goodwill usually exists only in group accounts. Groups are not taxed as such: it is the members of
a group that are the taxable entities, i.e. the parent and each subsidiary are taxed separately.
Goodwill in group accounts is not an asset recognised by the tax authorities so has a tax base of
nil. This means that goodwill is a temporary difference but does not lead to the recognition of a
deferred tax liability because of the exception.

Example: Goodwill
In the year ended 31 December 2016, A Limited acquired 80% of another company and
recognised goodwill of Rs. 100,000 in respect of this acquisition.
The relevant tax rate is 30%.
Carrying Temporary
amount Tax base difference
Rs. Rs. Rs.
Goodwill 100,000 nil 100,000

Deferred tax (due to the exception) nil

The exception refers to the initial recognition of goodwill. However, there is no deferred tax in
respect of this difference at any time in the future even if the carrying amount (and hence the
temporary difference) changes..

In some jurisdictions goodwill can arise in individual company financial statements. Furthermore,
the goodwill might be tax deductible in those jurisdictions. In such cases goodwill is just the same
as any other asset and its tax consequences would be recognised in the same way.

Example: Goodwill
In the year ended 31 December 2016, B Limited acquired a partnership and recognised good will
of Rs. 100,000 in respect of this acquisition.
The relevant tax rate is 30%.

© Emile Woolf International 411 The Institute of Chartered Accountants of Pakistan

Advanced accounting and financial reporting

Example: Goodwill (continued)

Carrying Temporary
amount Tax base difference
Rs. Rs. Rs.
Goodwill 100,000 100,000 nil
Deferred tax on initial recognition nil

In the future, both the carrying amount and the tax base of the goodwill might change leading to
deferred tax consequences.

Comment on the exceptions: Initial recognition of other items

A temporary difference may arise on initial recognition of an asset or liability, for example if part or
all of the cost of an asset will not be deductible for tax purposes. This exception relates to the initial
recognition of an asset or liability in a transaction that is not a business combination. In other words,
the exception does not apply if the initial recognition is due to a business combination. There is
guidance on deferred tax arising in business combinations
If the transaction is not a business combination and affects either accounting profit or taxable profit
the exception does not apply and deferred tax is recognised on initial recognition.

Example: Loan
In the year ended 31 December 2016, C Limited lent Rs. 100,000 to another company and incurred
costs of Rs. 5,000 in arranging the loan. The loan is recognised at Rs. 105,000 in the accounts.
Under the tax rules in C Limited’s jurisdiction the cost of arranging the loan is deductible in the
period in which the loan is made.
The relevant tax rate is 30%.
Carrying Temporary
amount Tax base difference
Rs. Rs. Rs.
Loan 105,000 100,000 5,000
Deferred tax on initial recognition 1,500
The exception does not apply as the transaction affects the taxable profits on initial recognition.
Hence a deferred taxation liability is booked.

If the transaction is not a business combination, and affects neither accounting profit nor taxable
profit, deferred tax would normally be recognised but the exception prohibits it.

Example: Initial recognition

In the year ended 31 December 2016, D Limited acquired a non-current asset at a cost of Rs.
100,000. The asset is to be depreciated on a straight line basis over its useful life of 5 years.
The asset falls outside the tax system. Depreciation is not allowable for tax purposes and there is
no tax deductible equivalent. Any gain on disposal is not taxable and any loss on disposal not
taxable.
The relevant tax rate is 30%.
Initial recognition:
Carrying Temporary
amount Tax base difference
Rs. Rs. Rs.
Non-current asset 100,000 Nil 100,000
Deferred tax on initial recognition (due to the exception) nil

© Emile Woolf International 412 The Institute of Chartered Accountants of Pakistan

 Chapter 18: IAS 12: Income taxes

Example: Initial recognition (continued)

Subsequent measurement (1 year later)
Carrying Temporary
amount Tax base difference
Rs. Rs. Rs.
Non-current asset 80,000 Nil 80,000
Deferred tax on initial recognition (due to the exception – this
still results from the initial recognition) nil

4.2 Recognition of deferred tax assets

IAS 12 brings a different standard to the recognition of deferred tax assets than it does to deferred
tax liabilities:
 liabilities are always be recognised in full (subject to certain exemptions); but
 assets may not be recognised in full (or in some cases at all).
IAS 12 rule
A deferred tax asset must be recognised for all deductible temporary differences to the extent that
it is probable that taxable profit will be available against which the deductible temporary difference
can be utilised, unless the deferred tax asset arises from the initial recognition of an asset or liability
in a transaction that:
 is not a business combination; and
 at the time of the transaction, affects neither accounting profit nor taxable profit (tax loss).
There is further guidance on the recognition of deferred tax asset in respect of deductible temporary
differences arising in a business combination
A deferred tax asset must only be recognised to the extent that it is probable that taxable profit will
be available against which the deductible temporary difference can be used.
Implication
In order to meet this requirement an entity must make an assessment of the probability that profits
will be available in the future against which the deferred tax asset might be utilised.
IAS 12 says that this will be the case when 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; or
 in periods into which a tax loss arising from the deferred tax asset can be carried back or
forward.
If this is not the case (i.e. there are insufficient taxable temporary differences relating to the same
taxation authority and the same taxable entity) a deferred tax asset is recognised only to the extent
that such profits exist or tax planning opportunities are available that will create taxable profit in
appropriate periods.
Tax planning opportunities are actions that could be taken in order to create or increase taxable
income in a particular period.
Deferred tax assets for unused tax losses
The availability of unused tax losses and unused tax credits that can be carried forward to reduce
future taxable profits will result in the recognition of a deferred tax asset according to the same
criteria as above. In other words, a deferred tax asset will be recognised to the extent that it is
probable that future taxable profit will be available against which the unused tax losses and unused
tax credits can be utilised.

© Emile Woolf International 413 The Institute of Chartered Accountants of Pakistan

Advanced accounting and financial reporting

Example: Unused tax losses

X Limited pays tax at 30%
In the year ended 31 December 2016, X Limited had incurred a taxable loss of Rs 200,000.
This was the first such loss suffered by the company. It fully expects to return to profit next year. In
fact its forecasts show an expected profit of Rs. 300,000 next year.
The company had a single taxable temporary difference as follows:
Analysis
The loss is fully recoverable against future taxable profits.
Conclusion
X Limited should recognise a deferred tax asset of Rs. 60,000 (30% Rs. 200,000).

However, the existence of unused tax losses is strong evidence that future taxable profit may not
be available. An entity with a history of recent losses may only recognise a deferred tax asset in
respect of unused tax losses or tax credits to the extent that:
 there are sufficient taxable temporary differences; or
 there is convincing other evidence that sufficient taxable profit will be available against which
they can be used.
In such circumstances, IAS 12 requires disclosure of the amount of the deferred tax asset and the
nature of the evidence supporting its recognition.

Example: Unused tax losses

X Limited pays tax at 30%
By the 31 December 2016 year-end, X Limited had unused taxable loss of Rs 200,000.
These losses had been building up over several recent years.
The company forecasts a profit of Rs. 300,000 next year. There is no convincing evidence that this
will be the case.
The company had a single taxable temporary difference as follows:.
Temporary
Carrying amount Tax base difference
Rs. Rs. Rs.
Non-current asset 1,500,000 1,380,000 120,000

Analysis
The loss is not fully recoverable against future taxable profits.
Conclusion
X Limited should recognise a deferred tax asset to the extent of the taxable
temporary differences. This is an amount of Rs. 36,000 (30% Rs. 120,000).

Review at the end of each period

IAS 12 requires that the carrying amount of a deferred tax asset must be reviewed at the end of
each reporting period to check if it is still probable that sufficient taxable profit is expected to be
available to allow the benefit of its use.
If this is not the case the carrying amount of the deferred tax asset must be reduced to the amount
that it is expected will be used in the future. Any such reduction might be reversed in the future if
circumstances change again.
IAS 12 also requires that unrecognised deferred tax assets should be reassessed at the end of
each reporting period. A previously unrecognised deferred tax asset will be recognised to the extent
that it has become probable that future taxable profit will allow the deferred tax asset to be
recovered.

© Emile Woolf International 414 The Institute of Chartered Accountants of Pakistan

 Chapter 18: IAS 12: Income taxes

4.3 A recognition issue – non-taxable items

The definition of temporary difference is repeated here for convenience:

Definition: Temporary difference

Temporary differences are differences between the carrying amount of an asset or liability in the
statement of financial position and its tax base.

Deferred tax should be recognised only in respect of those items where expense or income is
recognised in both accounting profit and taxable profit but in different periods.
Unfortunately, applying the definition of temporary difference given above would result in the
inclusion of items where the difference might not be temporary but permanent in nature.

Example: Permanent difference.

E Limited has recognised Rs. 100,000 income as a receivable in its accounting profit for the year.
This income is not taxable.
Applying the definition of temporary difference would lead to the following:
Carrying Temporary
amount Tax base difference
Rs. Rs. Rs.
Receivable 100,000 nil 100,000

However, this is not a temporary difference. It is not a transaction recognised in

accounting profits in one period and taxable profits in another.
It is never recognised in taxable profits.

Items not taxable or tax allowable should not result in the recognition of deferred tax balances. In
order to achieve this effect, IAS 12 includes the following rules:
 the tax base of an asset is the amount that will be deductible for tax purposes against any
taxable economic benefits that will flow to an entity when it recovers the carrying amount of
the asset. If those economic benefits will not be taxable, the tax base of the asset is equal
to its carrying amount.
 the tax base of a liability is its carrying amount, less any amount that will be deductible for
tax purposes in respect of that liability in future periods. In the case of revenue which is
received in advance, the tax base of the resulting liability is its carrying amount, less any
amount of the revenue that will not be taxable in future periods.
Returning to the above example:

Example: Permanent difference.

E Limited has recognised Rs. 100,000 income as a receivable in its accounting profit for the year.
This income is not taxable.
Applying the definition of temporary difference would lead to the following:
Carrying Temporary
amount Tax base difference
Rs. Rs. Rs.
Receivable 100,000 100,000 nil
The item is not taxable so its tax base is set to be the same as its carrying
amount.
This results in a nil temporary difference and prevents the recognition of
deferred tax on this asset.

© Emile Woolf International 415 The Institute of Chartered Accountants of Pakistan

Advanced accounting and financial reporting

This sounds rather complicated but just remember that it is a mechanism to exclude non-taxable
items from the consideration of deferred tax (even though the definition might have included them).
Remember this: there is no deferred tax to recognise on items that are not taxed or for which
no tax relief is given.
Closing comment
Accounting for deferred taxation restores the relationship that should exist between the profit
before tax in the financial statements, the tax rate and the tax charge. In earlier examples we saw
that after accounting for deferred tax the tax expense (current and deferred tax) was equal to the
tax rate  the accounting profit before tax.
This will not be the case if there are permanent differences.

4.4 Measurement of deferred tax balances

Discounting
Deferred tax assets and liabilities must not be discounted.
Tax rates
Deferred tax assets and liabilities must be measured at the tax rates that are expected to apply to
the period when the asset is realised or the liability is settled, based on tax rates (and tax laws)
that have been enacted or substantively enacted by the end of the reporting period.
Manner of settlement
Deferred tax balances must be measured in a way that reflects the tax consequences that would
follow from the manner in which the entity expects to recover or settle the carrying amount of its
assets and liabilities.
For example, the tax rate that applies might depend on whether an asset is used to generate profits
or is sold. The tax rate used would depend on how the asset is expected to be recovered in the
future.
In addition to this general guidance, IAS 12 also provides specific guidance as follows:
 Deferred tax balances arising from the revaluation of a non-depreciable asset (IAS 16) must
be measured to reflect the tax consequences of recovering its carrying amount through sale.
 There is a rebuttable presumption that the carrying amount of an investment property will be
recovered through sale when it is measured using the IAS 40 fair value model.

© Emile Woolf International 416 The Institute of Chartered Accountants of Pakistan

 Chapter 18: IAS 12: Income taxes

5 DEFERRED TAX: BUSINESS COMBINATIONS

Section overview

 Introduction
 Revaluation of assets/liabilities in the fair value exercise
 Unremitted earnings of group companies
 Unrealised profit adjustments
 Change in recoverability of parent’s deferred tax asset due to an acquisition

5.1 Introduction
Additional deferred tax items need to be considered in preparing group accounts, because new
sources of temporary differences arise:
 revaluation of assets/liabilities in the fair value exercise;
 unremitted earnings of group companies;
 unrealised profit adjustments.

5.2 Revaluation of assets/liabilities in the fair value exercise

When a parent company makes an acquisition, it must perform a fair value exercise on the assets
and liabilities of the entity it has acquired. This will result in a change in the carrying value of some
of the assets and liabilities. However, the tax base will not be affected, as this is based on the
original cost.
Temporary differences arise for all the revalued assets and liabilities
Double entry
The deferred tax is recognised automatically during the consolidation process. There is no need to
make a specific double entry.

Example: Fair value exercise and deferred tax

P Ltd acquires a 100% subsidiary on 31 December 20X6.for Rs. 600,000.
The subsidiary’s deferred taxation position at the date of acquisition was as follows:

Temporary
Book value Tax base differences
Rs. 000 Rs. 000 Rs. 000
Property, plant and equipment 180 150 30
Accounts receivable 210 210 -
Inventory 124 124 -
Pension liability - - -
Accounts payable (120) (120) -
Temporary differences 30
Deferred tax at 30% 9

© Emile Woolf International 417 The Institute of Chartered Accountants of Pakistan

Advanced accounting and financial reporting

Example: Fair value exercise and deferred tax

P Ltd carries out a fair value exercise.
The deferred tax balance must be recomputed to take account of the fair value differences as
follows:

Temporary
Fair value Tax base differences
Rs. 000 Rs. 000 Rs. 000
Property, plant and equipment 270 150 120
Accounts receivable 210 210 -
Inventory 174 124 50
Pension liability (30) - (30)
Accounts payable (120) (120) -
Fair value of net assets 504
Temporary differences 140
Deferred tax at 30% 42

The deferred tax balance of Rs. 9,000 must be increased to Rs. 42,000 in the
consolidation workings.
Goodwill is calculated as follows:
Rs. 000
Cost of investment 600
Fair value of net assets acquired (as in the
statement of financial position) 504
Deferred tax arising on fair value exercise (42)
(462)
Goodwill on acquisition 138

5.3 Unremitted earnings of group companies

When a company acquires a subsidiary or associate, it acquires a right to receive dividends out of
its accumulated profits. A temporary difference arises on the profits of the subsidiary or associate
that have not been distributed to the parent as at the date of consolidation. For clarity, this is the
parent’s share of the subsidiary’s post acquisition retained profit.
IAS 12 requires that a deferred tax liability be recognised for these undistributed earnings, because
they will attract tax when the dividends are paid to the parent in the future.
However, deferred taxation is not recognised on such amounts when:
 the parent is able to control the timing of the reversal of the temporary difference (i.e. the
timing of when the dividend is paid); and
 it is probable that the temporary difference will not reverse in the future (i.e. there is no
intention to instigate the payment of a dividend).
In practice, it is unusual to see companies recognising deferred tax liability for undistributed profits
of a subsidiary because of the above rule.

© Emile Woolf International 418 The Institute of Chartered Accountants of Pakistan

 Chapter 18: IAS 12: Income taxes

The situation for investments in associates is different because the parent is unlikely to control the
timing of the reversal of the temporary difference. Recognition of deferred tax liability for
undistributed profits of associates is quite common.

5.4 Unrealised profit adjustments

Where inter-company trading takes place between group companies and the inventory is still held
by the group at the year end, an adjustment is made in the group accounts because the profit has
not been realised outside of the group.
However, tax is charged on the profits of the individual companies, not on the group as a whole.
The profit on intra-group sales will therefore be subjected to tax, and this will create a temporary
difference.
The issue to resolve is whose tax rate should be used when providing for the deferred tax on this
temporary difference – the seller’s or the buyer’s? IAS 12 requires that deferred tax be provided at
the buyer’s rate of tax.

5.5 Change in recoverability of parent’s deferred tax asset due to an acquisition

A parent company may have a deferred tax asset that it has not recognised as it does not believe
it probable that taxable profits will be available against which the asset can be used.
The probability of realising a pre-acquisition deferred tax asset of the acquirer could change as a
result of a business combination.
For example, the acquirer may be able to utilise the benefit of its unused tax losses against the
future taxable profit of the acquiree.
In such cases, the parent company should recognise the change in the deferred tax asset in the
period of the business combination. This does not affect the goodwill calculation.

© Emile Woolf International 419 The Institute of Chartered Accountants of Pakistan

Advanced accounting and financial reporting

6 PRESENTATION AND DISCLOSURE

Section overview

 Presentation
 Disclosure

6.1 Presentation
IAS 12: Income taxes contains requirements on when current tax liabilities may be offset against
current tax assets
Offset of current tax liabilities and assets
A company must offset current tax assets and current tax liabilities if, and only if, it:
 has a legally enforceable right to set off the recognised amounts; and
 intends either to settle on a net basis, or to realise the asset and settle the liability
simultaneously.
These are the same rules as apply to assets and liabilities in general as described in IAS 1.
In the context of taxation balances whether a current tax liability and asset may be offset is usually
specified in tax law, thus satisfying the first criterion.
In most cases, where offset is legally available the asset would then be settled on a net basis (i.e.
the company would pay the net amount).
Offset of deferred tax liabilities and assets
A company must offset deferred tax assets and deferred tax liabilities if, and only if:
 the entity has a legally enforceable right to set off current tax assets against current tax
liabilities; and
 the deferred tax assets and the deferred tax liabilities relate to income taxes levied by the
same taxation authority on either:
 the same taxable entity; or
 different taxable entities which intend either to settle current tax liabilities and assets
on a net basis, or to realise the assets and settle the liabilities simultaneously, in each
future period in which significant amounts of deferred tax liabilities or assets are
expected to be settled or recovered.
The existence of deferred tax liability is strong evidence that a deferred tax asset from the same
tax authority will be recoverable.

Example: Offset of deferred tax liabilities and assets

The following deferred tax positions relate to the same entity:
Situation 1 Situation 2
Deferred tax liability 12,000 5,000
Deferred tax asset (8,000) (8,000)
4,000 (3,000)
In situation 1, the financial statements will report the net position as a liability of 4,000. The
existence of the liability indicates that the company will be able to recover the asset, so the asset
can be set off against the liability.
In situation 2, setting off the asset against the liability leaves a deferred tax asset of 3,000. This
asset may only be recognised if the entity believes it is probable that it will be recovered in the
foreseeable future.

© Emile Woolf International 420 The Institute of Chartered Accountants of Pakistan

 Chapter 18: IAS 12: Income taxes

6.2 Disclosure
Components of tax expense (income)
The major components of tax expense (income) must be disclosed separately.
Components of tax expense (income) may include:
 current tax expense (income);
 any adjustments recognised in the period for current tax of prior periods;
 the amount of deferred tax expense (income) relating to the origination and reversal of
temporary differences;
 the amount of deferred tax expense (income) relating to changes in tax rates or the
imposition of new taxes;
 the amount of the benefit arising from a previously unrecognised tax loss, tax credit or
temporary difference of a prior period that is used to reduce current tax expense;
 deferred tax expense arising from the write-down, or reversal of a previous write-down, of a
deferred tax asset;
 the amount of tax expense (income) relating to those changes in accounting policies and
errors that are included in profit or loss in accordance with IAS 8, because they cannot be
accounted for retrospectively.

Illustration: Note to the statement of comprehensive income

Taxation expense Rs.

Current tax 129,000
Adjustment for over estimate of tax in prior year (5,000)
Deferred taxation
Arising during the period 20,000
Due to change in tax rate (5,000)
15,000
139,000

Example: Change in rate

31 December 2015
Profits were taxed at 30%.
A Limited recognised a deferred tax liability of Rs. 30,000 (it had temporary differences of Rs.
100,000).
31 December 2016
The tax rate changed to 25% during the year.
At the year- end A Limited carried out the following deferred tax calculation:
Carrying Temporary
amount Tax base difference
Rs. Rs. Rs.
Non-current assets 1,000,000 820,000 180,000
Deferred tax at 25% 45,000

© Emile Woolf International 421 The Institute of Chartered Accountants of Pakistan

Advanced accounting and financial reporting

Example: Change in rate (continued)

The movement on the deferred tax liability would be shown as follows:

Rs.

Deferred taxation b/f 30,000

Statement of comprehensive income: Rate change (5/30  30,000) (5,000)

Deferred taxation b/f restated 25,000

Statement of comprehensive income (balancing figure – due to the

origination of temporary differences in the period) 20,000

Deferred taxation balance at the end of the year (working) 45,000

Journal: Debit Credit

Income statement (tax expense) 5,000

Income statement (tax expense) 20,000

Deferred tax liability 15,000

Tax reconciliation
The following must also be disclosed:
 an explanation of the relationship between tax expense (income) and accounting profit in
either or both of the following forms:
 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
 a numerical reconciliation between the average effective tax rate and the applicable
tax rate, disclosing also the basis on which the applicable tax rate is computed;
 an explanation of changes in the applicable tax rate(s) compared to the previous accounting
period;
A major theme in this chapter is that the different rules followed to calculate accounting profit and
taxable profit lead to distortion of the relationship that exists between profit before tax in the
financial statements, the tax rate and the current tax expense for the period. Accounting for
deferred tax corrects this distortion so that after accounting for deferred tax the tax expense
(current and deferred tax) was equal to the tax rate  the accounting profit before tax.
This is not the case if there are permanent differences. The above reconciliations show the effect
of permanent differences.
Instances of when permanent differences may arise:
 Exempt Income e.g. capital gains
 Non-Allowable expense e.g. penalties
 Income taxable at lower or higher rates e.g. dividend income

© Emile Woolf International 422 The Institute of Chartered Accountants of Pakistan

 Chapter 18: IAS 12: Income taxes

Include example of Dividend

Example: Tax reconciliations

B Limited had an accounting profit before tax of Rs. 500,000.
This contained income of Rs. 20,000 which is not taxable.
Accounting depreciation in the year was Rs. 100,000 and tax allowable depreciation was Rs.
150,000. This means that a temporary difference of Rs. 50,000 originated in the year.

B Limited’s taxation computation is as follows: Rs.

Accounting profit 500,000
Add back inadmissible deductions
Depreciation 100,000
Deduct admissible deduction
Income not taxed (20,000)
Assessable profit 580,000
Tax allowable depreciation (150,000)
Taxable profit 430,000
Tax at 30% 129,000
Tax expense
Current tax 129,000
Deferred taxation (30%  Rs. 50,000) 15,000
Tax expense 144,000
Tax reconciliation (in absolute numbers)
Accounting profit 500,000
Applicable tax rate 30%
Accounting profit  the applicable tax rate 150,000
Tax effect of untaxed income (30% of Rs. 20,000) (6,000)
Tax expense 144,000
Tax reconciliation (in percentages)
Applicable tax rate 30.0%
Tax effect of untaxed income (6,000/500,000) (1.2%)
Effective tax rate (144,000/500,000) 28.8%
Note: this difference arises only when there are permanent differences

Other disclosures
The following must also be disclosed separately:
 the aggregate current and deferred tax relating to items recognised directly in equity;
 the amount of income tax relating to each component of other comprehensive income;
 details (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;
 the aggregate amount of temporary differences associated with investments in subsidiaries,
branches and associates and interests in joint arrangements, for which deferred tax liabilities
have not been recognised;

© Emile Woolf International 423 The Institute of Chartered Accountants of Pakistan

Advanced accounting and financial reporting

 in respect of each type of temporary difference, and in respect of each type of unused tax
losses and unused tax credits:
 the amount of the deferred tax assets and liabilities recognised in the statement of
financial position for each period presented;
 the amount of the deferred tax income or expense recognised in profit or loss if not
apparent from the changes in the amounts recognised in the statement of financial
position;
 in respect of discontinued operations, the tax expense relating to:
 the gain or loss on discontinuance; and IAS 12
 the profit or loss from the ordinary activities of the discontinued operation for the
period, together with the corresponding amounts for each prior period presented;
 the amount of income tax consequences of dividends to shareholders proposed or declared
before the financial statements were authorised for issue, but are not recognised as a liability
in the financial statements;
 the amount of any change recognised for an acquirer’s pre-acquisition deferred tax asset
caused by a business combination; and
 the reason for the recognition of a deferred tax benefits acquired in a business combination
recognised at the acquisition date but not recognised at the acquisition date.
 the amount of a deferred tax asset and the nature of the evidence supporting its recognition,
when:
 the utilisation of the deferred tax asset is dependent on future taxable profits in excess
of the profits arising from the reversal of existing taxable temporary differences; and
 the entity has suffered a loss in either the current or preceding period in the tax
jurisdiction to which the deferred tax asset relates.

© Emile Woolf International 424 The Institute of Chartered Accountants of Pakistan

 Chapter 18: IAS 12: Income taxes

Practice questions 1
XYZ Limited had an accounting profit before tax of Rs. 90,000 for the year ended 31st
December 2016. The tax rate is 30%.
The following balances and information are relevant as at 31st December 2016.

Non-current assets Rs. Rs.

Property 63,000 1
Plant and machinery 100,000 90,000 2
Assets held under finance lease 80,000 3
Receivables:
Trade receivables 73,000 4
Interest receivable 1,000 5
Payables
Fine 10,000
Finance lease obligation 85,867 3
Interest payable 3,300 5

Note 1: The property cost the company Rs. 70,000 at the start of the year. It is being
depreciated on a 10% straight line basis for accounting purposes.
The company’s tax advisers have said that the company can claim Rs. 42,000
accelerated depreciation as a taxable expense in this year’s tax computation.

Note 2: The balances in respect of plant and machinery are after providing for accounting
depreciation of Rs. 12,000 and tax allowable depreciation of Rs. 10,000 respectively.

Note 3: The asset held under the finance lease was acquired during the period.
The tax code does not distinguish between finance leases and operating leases. Rental
expense for leases is tax deductible. The annual rental for the asset is Rs. 28,800 and
was paid on 31st December 2017.

Note 4: The receivables figure is shown net of an allowance for doubtful balances of Rs.
7,000. This is the first year that such an allowance has been recognised. A deduction for
debts is only allowed for tax purposes when the debtor enters liquidation.

Note 5: Interest income is taxed and interest expense is allowable on a cash basis. There
were no opening balances on interest receivable and interest payable.

a. Prepare a tax computation and calculate the current tax expense.

b. Calculate the deferred tax liability required as at 31 December 2016.

c. Show the movement on the deferred tax account for the year ended 31 December 2016
given that the opening balance was Rs. 3,600 Cr.

d. Prepare a note showing the components of the tax expense for the period.

e. Prepare a reconciliation between the tax expense and the product of the accounting
profit multiplied by the applicable rate.

© Emile Woolf International 425 The Institute of Chartered Accountants of Pakistan

Advanced accounting and financial reporting

SOLUTIONS TO PRACTICE QUESTIONS

Solution: Tax computation for the year ended 31 December 2016 1a
Rs. Rs.
Accounting profit 90,000
Add back inadmissible expenses
Depreciation on property 7,000
Depreciation of plant and machinery 12,000
Depreciation of asset held under finance lease 20,000
Finance charge re finance lease 14,667
Increase in provision for doubtful debts 7,000
Interest payable accrual 3,300
Fine 10,000 73,967
Less admissible deductions
Interest income 1,000
Tax allowable depreciation on property 42,000
Tax allowable depreciation on plant and machinery 10,000
Lease rentals 28,800 (81,800)
82,167
Tax 30% 24,650

Solution: Deferred tax liability as 31 December 2016 1b

Carrying Temporary
value Tax base difference
Rs. Rs. Rs.
Property 63,000 28,000 35,000
Plant and machinery 100,000 90,000 10,000
Assets held under finance lease 80,000 nil 80,000
Finance lease obligation (85,867) nil (85,867)
(5,867) nil (5,867)
Trade receivables 73,000 80,000 (7,000)
Interest receivable 1,000 nil 1,000
Fine (10,000) (10,000) 
Interest payable (3,300) nil (3,300)
29,833
Deferred tax @ 30% 8,950

Temporary Deferred tax

differences @ 30%
Deferred tax liabilities 46,000 13,800
Deferred tax assets (16,167) (4,850)
8,950

© Emile Woolf International 426 The Institute of Chartered Accountants of Pakistan

 Chapter 18: IAS 12: Income taxes

Solution: Movement on the deferred tax account for the year ended 31 December 2016. 1c
Rs.
Deferred tax as at 1st January 2016 3,600
Statement of comprehensive income (balancing figure) 5,350
Deferred tax as at 31st December 2016 8,950

Solution: Components of tax expense for the year ended 31 December 2016. 1d
Rs.
Current tax expense (see part a) 24,650
Deferred tax (see part c) 5,350
Tax expense 30,000

Solutions: Tax reconciliation for the year ended 31 December 2016. 1e

Rs.
Accounting profit 90,000
Tax at the applicable rate (30%) 27,000
Tax effects of expenses that are not deductible in determining taxable
profit
Fines 3,000
Tax expense 30,000

© Emile Woolf International 427 The Institute of Chartered Accountants of Pakistan

Advanced accounting and financial reporting

© Emile Woolf International 428 The Institute of Chartered Accountants of Pakistan

 Certified Finance and Accounting Professional

19

CHAPTER
Advanced accounting and financial reporting

Presentation of financial statements

Contents
1 IAS 34: Interim financial reporting
2 IAS 24: Related party disclosures

© Emile Woolf International 429 The Institute of Chartered Accountants of Pakistan

Advanced accounting and financial reporting

1 IAS 34: INTERIM FINANCIAL REPORTING

Section overview

 Scope of IAS 34
 Form and content of interim financial statements
 Periods for which interim financial statements must be presented
 Recognition and measurement
 Use of estimates in interim financial statements
 Disclosures

1.1 Scope of IAS 34

IAS 1 requires that financial statements should be produced at least annually. Many companies
are required by national regulations to produce accounts on a half-yearly basis or sometimes on a
quarterly basis. For example, the Listing Regulations of Pakistan requires listed companies whose
shares are traded on the Pakistan Stock Exchange to present financial statements on quarterly,
half yearly and annual basis.
IAS 34 Interim financial reporting does not specify the frequency of interim reporting. However,
governments, securities regulators, stock exchanges, and accountancy bodies often require
entities whose debt or equity securities are publicly traded to publish interim financial reports. IAS
34 focuses on providing guidance on the form and content of these interim accounts.
It encourages publicly-traded entities to prepare interim financial reports at least as of the end of
the first half of their financial year and to file them with the regularity authority no later than 60 days
after the end of the interim period.

1.2 Form and content of interim financial statements

IAS 34 requires that, as a minimum, an interim financial report should include:
 a condensed statement of financial position
 a condensed statement of profit or loss and other comprehensive income, presented as
either a condensed single statement or a condensed separate statement of profit or loss
followed by a condensed statement of other comprehensive income
 a condensed statement of changes in equity
 a condensed statement of cash flows, and
 selected explanatory notes.
In the statement that presents the components of profit or loss an entity should present the basic
and diluted EPS for the period.
If an entity publishes a set of condensed financial statements in its interim financial report, those
condensed statements shall include, at a minimum, each of the headings and subtotals that were
included in its most recent annual financial statements and the selected explanatory notes as
required by this Standard. Additional line items or notes shall be included if their omission would
make the condensed interim financial statements misleading
The interim statements are designed to provide an update on the performance and position of the
entity. It should focus on new activities, events, and circumstances that have occurred since the
previous annual financial statements were issued. They should not duplicate information that has
already been reported in the past.

© Emile Woolf International 430 The Institute of Chartered Accountants of Pakistan

 Chapter 19: Presentation of financial statements

1.3 Periods for which interim financial statements must be presented

Interim reports must include the following financial statements (condensed or complete):
 a statement of financial position at the end of the current interim period and a comparative
balance sheet at the end of the previous financial year.
 statements of profit or loss and other comprehensive income for the current interim period
and cumulatively for the current financial year to date.
 comparative statements of profit or loss and other comprehensive income for the
comparable interim period last year, and the comparable cumulative period last year.
 a statement of changes in equity for the current financial year to date, with a comparative
statement for the comparable year-to-date period in the previous year.
 a statement of cash flows cumulatively for the current financial year to date, with a
comparative statement for the comparable year-to-date period in the previous year.

Example: Periods for which interim financial statements must be presented

X plc publishes interim financial reports quarterly.
The entity's financial year ends 31 December (calendar year).
The statements that must be presented in the quarterly interim report as of 30 June 20X7:
31st
30th June 30th June
December
20X6 20X7
20X6
Statement of financial position -  

Statement of profit or loss and

other comprehensive income
6 months ending  - 
3 months ending  - 

Statement of cash flows

6 months ending  - 
3 months ending - - -

Statement of changes in equity

6 months ending  - 
3 months ending - - -

Note: the profit and loss statement will have four columns.

1.4 Recognition and measurement

An entity should use the same accounting policies in the interim accounts that it uses in the annual
financial statements.
Measurement for interim purposes should be made on a year-to-date basis. For example, suppose
that a company uses quarterly reporting and in the first quarter of the year, it writes down some
inventory to zero. If it is then able to sell the inventory in the next quarter, the results for the six-
month period require no write-down of inventory, and the write-down of inventory should be
reversed for the purpose of preparing the interim accounts for the first six months of the year.
An appendix to IAS 34 gives some guidance on applying the general recognition and measurement
rules from the IASB Conceptual Framework to the interim accounts. Some examples are given
below.

© Emile Woolf International 431 The Institute of Chartered Accountants of Pakistan

Advanced accounting and financial reporting

Intangible assets
The guidance in IAS 34 states that an entity should follow the normal recognition criteria when
accounting for intangible assets. Development costs that have been incurred by the interim date
but do not meet the recognition criteria should be expensed. It is not appropriate to capitalise them
as an intangible asset in the belief that the criteria will be met by the end of the annual reporting
period.
Tax
Interim period income tax expense is accrued using the tax rate that would be applicable to
expected total annual earnings, that is, the estimated average annual effective income tax rate
applied to the pre-tax income of the interim period.
The following examples illustrate the application of the foregoing principle.

Example: Interim period income tax expense

An entity publishes interim financial reports quarterly.
It expects to earn Rs. 10,000 pre-tax each quarter and operates in a jurisdiction with a tax rate of
20% on the first 20,000 of annual earnings and 30% on all additional earnings.
Actual earnings match expectations.
The following table shows the amount of income tax expense that is reported in each quarter:
1st 2nd 3rd 4th Annual
Quarter Quarter Quarter Quarter total
Tax expense 2,500 2,500 2,500 2,500 10,000
Rs. 10,000 of tax is expected to be payable for the full year on Rs. 40,000 of pre-
tax income.
An entity publishes interim financial reports quarterly.
The entity earns 15,000 pre-tax profit in the first quarter but expects to incur losses of 5,000 in
each of the three remaining quarters (thus having zero income for the year), and operates in a
jurisdiction in which its estimated average annual income tax rate is expected to be 20%.
The following table shows the amount of income tax expense that is reported in each quarter:
1st 2nd 3rd 4th Annual
Quarter Quarter Quarter Quarter total
Tax expense 3,000 (1,000) (1,000) (1,000) nil

1.5 Use of estimates in interim financial statements

The interim financial statements should be reliable and relevant. However, IAS 34 recognises that
the preparation of interim accounts will generally rely more heavily on estimates than the annual
financial statements. An appendix of IAS 34 provides examples.
Pensions
A company is not expected to obtain an actuarial valuation of its pension liabilities at the interim
date. The guidance suggests that the most recent valuation should be rolled forward and used in
the interim accounts.
Provisions
The calculation of some provisions requires the assistance of an expert. IAS 34 recognises that
this would be too costly and time-consuming for the interim accounts. IAS 34 therefore states that
the figure included in the annual financial statements for the previous year should be updated
without reference to an expert.
Inventories
A full count of inventory may not be necessary at the interim reporting date. It may be sufficient to
make estimates based on sales margins to establish a valuation for the interim accounts.

© Emile Woolf International 432 The Institute of Chartered Accountants of Pakistan

 Chapter 19: Presentation of financial statements

1.6 Disclosures
The following is a list of events and transactions for which disclosures would be required if they are
significant: the list is not exhaustive.
(a) the write-down of inventories to net realisable value and the reversal of such a write-down;
(b) recognition of a loss from the impairment of financial assets, property, plant and equipment,
intangible assets, assets arising from contracts with customers, or other assets, and the
reversal of such an impairment loss;
(c) the reversal of any provisions for the costs of restructuring;
(d) acquisitions and disposals of items of property, plant and equipment;
(e) commitments for the purchase of property, plant and equipment;
(f) litigation settlements;
(g) corrections of prior period errors;
(h) changes in the business or economic circumstances that affect the fair value of the entity’s
financial assets and financial liabilities, whether those assets or liabilities are recognised at fair
value or amortised cost;
(i) any loan default or breach of a loan agreement that has not been remedied on or before the
end of the reporting period;
(j) related party transactions;
(k) transfers between levels of the fair value hierarchy used in measuring the fair value of financial
instruments;
(l) changes in the classification of financial assets as a result of a change in the purpose or use
of those assets; and
(m) changes in contingent liabilities or contingent assets
An entity shall include the following information, in the notes to its interim financial statements or
elsewhere in the interim financial report. The information shall normally be reported on a financial
year-to-date basis.
(a) a statement that the same accounting policies and methods of computation are followed in the
interim financial statements as compared with the most recent annual financial statements
(b) explanatory comments about the seasonality or cyclicality (particularly revenue) of interim
operations.
(c) the nature and amount of items affecting assets, liabilities, equity, net income or cash flows
that are unusual because of their nature, size or incidence.
(d) the nature and amount of changes in estimates of amounts reported in prior interim periods of
the current financial year or changes in estimates of amounts reported in prior financial years.
(e) issues, repurchases and repayments of debt and equity securities.
(f) dividends paid (aggregate or per share) separately for ordinary shares and other shares.
(g) the disclosure of segment information is required in an entity’s interim financial report only if
IFRS 8 Operating Segments requires that entity to disclose segment information in its annual
financial statements)
In addition to above, other specific disclosure shall be required pertaining to following IFRS;
(h) IAS 10
(i) IFRS 3
(j) IFRS 7 and IFRS 13
(k) IFRS 10 and IFRS 12
(l) IFRS 15

© Emile Woolf International 433 The Institute of Chartered Accountants of Pakistan

Advanced accounting and financial reporting

2 IAS 24: RELATED PARTY DISCLOSURES

Section overview

 Impact on the financial statements

 The objective and scope
 Definitions
 Disclosure requirements

2.1 Impact on the financial statements

A user of financial statements will normally expect the financial statements to reflect transactions
that have taken place on normal commercial terms (‘at arm’s length’). The user of the financial
statements would want to be informed if:
 Transactions have taken place that were not at ‘arm’s length’; or
 There are parties that could enforce transactions on the entity that are not on an ‘arm’s
length’ basis.
For example, in a group of companies, an entity might sell goods to its parent or fellow-subsidiaries
on more favourable terms than it would sell to other customers.
In this situation, the financial performance or financial position reported by the financial statements
would be misleading. In each situation there is a special relationship between the parties to the
business transactions. This is referred to as a ‘related party relationship’.

2.2 The objective and scope

The objective of IAS 24 is to ensure that an entity’s financial statements contain sufficient
disclosures to draw attention to the possibility that the entity’s financial position, or profit or loss
may have been affected by:
 the existence of related parties; and
 transactions and outstanding balances with related parties.
IAS 24 is neither deal with classification, recognition and measurement but it is only a disclosure
standard.
It shall be applied in:
(a) identifying related party relationships and transactions;
(b) identifying outstanding balances, including commitments, between an entity and its related
parties; and
(c) determining the disclosures to be made about those items.

2.3 Definitions
IAS 24 provides a lengthy definition of a related party and also a definition of a related party
transaction.
Related party

Definition: Related party

A related party is a person or entity that is related to the entity that is preparing its financial
statements (the reporting entity).

a) A person or a close member of that person’s family is related to a reporting entity if that
person:

© Emile Woolf International 434 The Institute of Chartered Accountants of Pakistan

 Chapter 19: Presentation of financial statements

i) has control or joint control over the reporting entity;

ii) has significant influence over the reporting entity; or

iii) is a member of the key management personnel of the reporting entity or of a parent
of the reporting entity.

b) An entity is related to a reporting entity if any of the following conditions applies:

i) The entity and the reporting entity are members of the same group (which means that
each parent, subsidiary and fellow subsidiary is related to the others).

ii) One entity is an associate or joint venture of the other entity (or an associate or joint
venture of a member of a group of which the other entity is a member).

iii) Both entities are joint ventures of the same third party.

iv) One entity is a joint venture of a third entity and the other entity is an associate of the
third entity.

v) The entity is a post-employment benefit plan for the benefit of employees of either
the reporting entity or an entity related to the reporting entity. If the reporting entity is
itself such a plan, the sponsoring employers are also related to the reporting entity.

vi) The entity is controlled or jointly controlled by a person identified in (a).

vii) A person identified in (a)(i) has significant influence over the entity or is a member of
the key management personnel of the entity (or of a parent of the entity).

viii) The entity, or any member of a group of which it is a part, provides key management
personnel services to the reporting entity of to the parent of the reporting entity.

A parent entity is related to its subsidiary entities (because it controls them) and its associated
entities (because it exerts significant influence over them). Fellow subsidiaries are also related
parties, because they are under the common control of the parent.
In considering each possible related party relationship the entity must look to the substance of the
arrangement, and not merely its legal form. Although two entities that have the same individual on
their board of directors would not meet any of the above conditions for a related party, a related
party relationship would nevertheless exist if influence can be shown.
Some examples are given by IAS 24 of likely exemptions, where a related party relationship
would usually not exist. However, the substance of the relationship should always be considered
in each case.
Examples of entities that are usually not related parties are:
 two entities simply because they have a director or other member of key management
personnel in common or because a member of key management personnel of one entity
has significant influence over the other entity.
 Two venturers that simply share joint control over a joint venture
 Providers of finance (such as a lending bank or a bondholder)
 Trade unions
 Public utilities
 Government departments and agencies
 Customers, suppliers, franchisors, distributors or other agents with whom the entity transacts
a significant volume of business.

© Emile Woolf International 435 The Institute of Chartered Accountants of Pakistan

Advanced accounting and financial reporting

Close family members

Definition:
Close family members
Close family members are those family members who may be expected to influence, or be
influenced by that individual.

Close family members include:

 an individual’s partner, spouse, children and dependants; and
 children or dependants of the individual’s partner or spouse.

Related party transactions

Definition:
Related party transaction
A related party transaction is a transfer of resources, services or obligations between a reporting
entity and a related party, regardless of whether a price is charged.

The following examples of related party transactions are given in IAS 24. (These are related party
transactions when they take place between related parties.)
 Purchases or sales of goods
 Purchases or sales of property and other assets
 Rendering or receiving of services
 Leases
 Transfer of research and development costs
 Finance arrangements (such as loans or contribution to equity)
 Provision of guarantees
 commitments to do something if a particular event occurs or does not occur in the future,
including executory contracts (recognised and unrecognised); and
 Settlement of liabilities on behalf of the entity or by the entity on behalf of another party.

Example: Related party transactions

In the following examples, identify related party relationships between all parties and state any
additional factors to consider in order to form a conclusion:
(a) W Plc holds a controlling interest in X Ltd and Y Ltd. Z Ltd is a wholly owned subsidiary of X
Ltd.
(b) Mr Z holds 75% of the voting capital of A Ltd and 40% of the voting capital of B Ltd.
(c) H and W (who are husband and wife) are the directors and majority shareholders of Q Ltd.
The company makes purchases from P Ltd, a company jointly controlled by W and their
daughter, D. D is a director of P Ltd but holds no share in Q Ltd.

© Emile Woolf International 436 The Institute of Chartered Accountants of Pakistan

 Chapter 19: Presentation of financial statements

Answer
(a) W Plc
W PLC is related to both X Ltd and Y Ltd (both subsidiaries) because of its controlling interest.
X Ltd and Y Ltd are related because they are under the common control of W PLC.
Z Ltd is related to X Ltd because of its subsidiary status.
Z Ltd is also related to W PLC as he is indirectly controlled by W PLC through W PLC’s holding
of X Ltd.
(b) Mr Z
Mr Z is related to A Ltd because of the subsidiary status of A Ltd.
As an associate of Mr Z, B Ltd is also a related party
A Ltd and B Ltd are not related. Although they are both owned by Mr Z, there is no common
control because Mr Z only has a 40% stake in B Ltd.
(c) Q Ltd
H and W are both related to Q Ltd, because they are key management of the entity
D could be considered to be close family to H and W, but this is only true if it can be shown
that she is influenced by them in business dealings (and there is insufficient information in
this example to ascertain whether this is true).
P Ltd is related to Q Ltd as it is jointly controlled by a member of the key management of Q
Ltd. Therefore any business dealings between the two entities will need to be disclosed.

2.4 Disclosure requirements

IAS 24 requires disclosure in the notes to the financial statements of the following, whether or not
transactions have taken place between those related parties:
 the name of the entity’s parent
 if different, the name of the ultimate controlling party
Where transactions have taken place between the related parties, irrespective of whether a price
was charged, the following should be disclosed:
 The nature of the related party relationship
 The amount of the transactions
 In respect of outstanding balances
 the amount
 their terms and conditions
 any guarantees given or received
 any provision for doubtful/irrecoverable debts
 The expense recognised in the period in respect of irrecoverable debts due from related
parties.
The above disclosures should be given separately for each of the following categories of related
party:
 The parent
 Entities with joint control or significant influence over the entity
 Subsidiaries
 Associates

© Emile Woolf International 437 The Institute of Chartered Accountants of Pakistan

Advanced accounting and financial reporting

 Joint ventures in which the entity is a venturer

 Key management personnel of the entity or its parent
 Other related parties
In addition, IAS 24 requires disclosure of compensation to key management personnel, in total,
and for each of the following categories:
 Short-term employee benefits
 Post-employment benefits
 Other long-term benefits
 Termination benefits
 Share-based payments.

Illustration: Disclosure note

An example of a note to the financial statements for related party transactions of a large quoted
company is shown below:
Trading transactions

Purchases Amounts owed Amounts owed

Sales to from related by related to related
related parties parties parties parties

Rs. m Rs. M Rs. m Rs. m

Associates - 48 - 17

Joint ventures 57 14 12 -

Non-trading transactions

Loans to Loans from

related parties related parties

Rs.m Rs.m

Associates - 11

Joint ventures 33 -

© Emile Woolf International 438 The Institute of Chartered Accountants of Pakistan

 Certified Finance and Accounting Professional

20

CHAPTER
Advanced accounting and financial reporting

IAS 36: Impairment of assets

Contents
1 Impairment of assets
2 Cash generating units
3 Other issues

© Emile Woolf International 439 The Institute of Chartered Accountants of Pakistan

Advanced accounting and financial reporting

1 IMPAIRMENT OF ASSETS
Section overview

 Objective and scope

 Identifying impairment or possible impairment
 Measuring recoverable amount
 Accounting for impairment
 Summary of the approach

1.1 Objective and scope

An asset is said to be impaired when its recoverable amount is less than its carrying amount in the
statement of financial position. The impairment is normally assessed at the end of the reporting
year (financial year end), however, where an indicator of impairment arises during a period then
impairment is assessed and loss be recognised at the end of interim reporting period.
The objective of IAS 36 Impairment of assets is to ensure that assets are ‘carried’ (valued) in the
financial statements at no more than their recoverable amount.
Scope
IAS 36 applies to accounting for impairment of all assets except the following:
 inventories (IAS 2: Inventories);
 assets arising from contracts with customers that are recognised in accordance with IFRS
15: Revenue from contracts with customers.
 deferred tax assets (IAS 12: Income taxes);
 assets arising from employee benefits (IAS 19: Employee Benefits);
 financial assets (IFRS 9: Financial instruments);
 Financial assets recognised and measured in accordance with IFRS 10: Consolidated
financial statements, IAS 27: Separate financial statements and IAS 28: Investments in
associates and joint ventures;
 investment property that is measured at fair value (IAS 40: Investment property);
 biological assets related to agricultural activity within the scope of IAS 41: Agriculture that
are measured at fair value less costs to sell;
 deferred acquisition costs, and intangible assets, arising from an insurer’s contractual rights
under insurance contracts within the scope of IFRS 4: Insurance contracts (but note that the
IAS 38 disclosure requirements do apply to those intangible assets); and
 non-current assets classified as held for sale (or included in a disposal group that is classified
as held for sale) (IFRS 5: Non-current assets held for sale and discontinued operations).
IAS 36 does apply to financial assets classified as:
 subsidiaries (IFRS 10: Consolidated financial statements);
 associates (IAS 28: Investments in associates and joint ventures); and
 joint ventures (IFRS 11: Joint arrangements).
Recoverable amount of assets

Definitions
The recoverable amount of an asset is defined as the higher of its fair value minus costs of disposal,
and its value in use.

© Emile Woolf International 440 The Institute of Chartered Accountants of Pakistan

 Chapter 20: Impairment of assets

Fair value is the price that would be received to sell an asset or paid to transfer a liability in an
orderly transaction between market participants at the measurement date.
Value in use is the present value of future cash flows from using an asset, including its eventual
disposal.
Impairment loss is the amount by which the carrying amount of an asset (or a cash-generating unit)
exceeds its recoverable amount.

Cash-generating units will be explained later.

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

1.2 Identifying impairment or possible impairment

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

External sources Internal sources

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

If there is an indication that an asset (or cash-generating unit) is impaired then it is tested for
impairment. This involves the calculating the recoverable amount of the item in question and
comparing this to its carrying amount.
Additional requirements for testing for impairment
The following assets must be reviewed for impairment at least annually, even when there is no
evidence of impairment:
 an intangible asset with an indefinite useful life; and
 goodwill acquired in a business combination.

© Emile Woolf International 441 The Institute of Chartered Accountants of Pakistan

Advanced accounting and financial reporting

1.3 Measuring recoverable amount

It has been explained that recoverable amount is the higher of an asset’s:

 fair value less costs of disposal; and

 its value in use.

If either of these amounts is higher than the carrying value of the asset, there has been no
impairment.
IAS 36 sets out the requirements for measuring ‘fair value less costs of disposal’ and ‘value in use’.
Measuring fair value less costs of disposal

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

Value in use represents the present value of the expected future cash flows from use of the asset,
discounted at a suitable discount rate or cost of capital.
Estimates of future cash flows should be based on reasonable and supportable assumptions that
represent management’s best estimate of the economic conditions that will exist over the remaining
useful life of the asset.
Estimates of future cash flows must include:

 cash inflows from the continuing use of the asset;

 cash outflows that will be necessarily incurred to generate the cash inflows from continuing
use of the asset; and

 net cash flow from disposal at the end of the asset’s useful life.
Estimates of future cash flows must not include:
 cash inflows or outflows from financing activities; or

 income tax receipts or payments.

Also note that future cash flows are estimated for the asset in its current condition. Therefore, any
estimate of future cash flows should not include estimated future cash flows that are expected to
arise from:

 a future restructuring to which an entity is not yet committed; or

 improving or enhancing the asset’s performance.

The discount rate must 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 flow estimates have not been
adjusted.
However, both the expected future cash flows and the discount rate might be adjusted to allow for
uncertainty about the future – such as the business risk associated with the asset and expectations
of possible variations in the amount or timing of expected future cash benefits from using the asset.

© Emile Woolf International 442 The Institute of Chartered Accountants of Pakistan

 Chapter 20: Impairment of assets

Example: Measurement of recoverable amount

A company has a machine in its statement of financial position at a carrying amount of
Rs.300,000.
The machine is used to manufacture the company’s best-selling product range, but the entry of a
new competitor to the market has severely affected sales.
As a result, the company believes that the future sales of the product over the next three years will
be only Rs. 150,000, Rs. 100,000 and Rs. 50,000. The asset will then be sold for Rs. 25,000.
An offer has been received to buy the machine immediately for Rs. 240,000, but the company
would have to pay shipping costs of Rs. 5,000.The risk-free market rate of interest is 10%.
Market changes indicate that the asset may be impaired and so the recoverable amount for the
asset must be calculated.

Fair value less costs of disposal Rs.

Fair value 240,000
Costs of disposal (5,000)
235,000

Year Cash flow (Rs.) Discount factor Present value

1 150,000 1/1.1 136,364
2 100,000 1/1.12 82,645
3 50,000 + 25,000 1/1.13 56,349
275,358

The recoverable amount is the higher of Rs. 235,000 and Rs. 275,358, i.e. Rs. 275,358.
The asset must be valued at the lower of carrying value and recoverable amount.
The asset has a carrying value of Rs. 300,000, which is higher than the recoverable amount
from using the asset.
It must therefore be written down to the recoverable amount, and an impairment of Rs.24,642
(Rs. 300,000 – Rs. 275,358) must be recognised.

1.4 Accounting for impairment

The impairment loss is normally recognised immediately in profit or loss.

Example: Measurement of recoverable amount

A company has a machine in its statement of financial position at a carrying amount of
Rs.300,000.
The machine has been tested for impairment and found to have recoverable amount of Rs.275,358
meaning that the company must recognise an impairment loss of Rs. 24,642.
This is accounted for as follows:
Debit Credit
Statement of profit or loss 24,642
Accumulated impairment loss 24,642
(Property, plant and equipment would be
presented net of the balance on this
account on the face of the statement of
financial position).

© Emile Woolf International 443 The Institute of Chartered Accountants of Pakistan

Advanced accounting and financial reporting

Practice question 1
On 1 January Year 1 Entity Q purchased for Rs. 240,000 a machine with an estimated useful
life of 20 years and an estimated zero residual value.
Depreciation is on a straight-line basis.
On 1 January Year 4 an impairment review showed the machine’s recoverable amount to be
Rs. 100,000 and its remaining useful life to be 10 years.
Calculate:
a) The carrying amount of the machine on 31 December Year 3 (immediately before the
impairment).
b) The impairment loss recognised in the year to 31 December Year 4.
c) The depreciation charge in the year to 31 December Year 4.

However, an impairment loss recognised in respect of an asset carried at a previously recognised

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

Example: Measurement of recoverable amount

A company has a machine in its statement of financial position at a carrying amount of Rs. 300,000
including a previously recognised surplus of Rs. 20,000.
The machine has been tested for impairment and found to have recoverable amount of Rs.
275,358 meaning that the company must recognise an impairment loss of Rs. 24,642.
This is accounted for as follows:
Debit Credit
Statement of profit or loss 4,642
Other comprehensive income 20,000
Property, plant and equipment 24,642

Following the recognition of the impairment, the future depreciation of the asset must be based on
the revised carrying amount, minus the residual value, over the remaining useful life.

Practice question 2
On 1 January Year 1 Entity Q purchased for Rs. 240,000 a machine with an estimated useful
life of 20 years and an estimated zero residual value.
Depreciation is on a straight-line basis.
The asset had been re-valued on 1 January Year 3 to Rs. 250,000, but with no change in
useful life at that date.
On 1 January Year 4 an impairment review showed the machine’s recoverable amount to
be Rs. 100,000 and its remaining useful life to be 10 years.
Calculate:
a) The carrying amount of the machine on 31 December Year 2 and hence the
revaluation surplus arising on 1 January Year 3.
b) The carrying amount of the machine on 31 December Year 3 (immediately before the
impairment).
c) The impairment loss recognised in the year to 31 December Year 4.
d) The depreciation charge in the year to 31 December Year 4.

© Emile Woolf International 444 The Institute of Chartered Accountants of Pakistan

 Chapter 20: Impairment of assets

1.5 Summary of the approach

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

© Emile Woolf International 445 The Institute of Chartered Accountants of Pakistan

Advanced accounting and financial reporting

2 CASH GENERATING UNITS

Section overview

 Elaborated
 Allocating an impairment loss

2.1 Elaborated
It is not always possible to calculate the recoverable amount of individual assets. Value in use often
has to be calculated for groups of assets because assets may not generate cash flows in isolation
from each other. An asset that is potentially impaired may be part of a larger group of assets which
form a cash-generating unit.
IAS 36 defines a cash-generating unit (CGU) as the smallest identifiable group of assets that
generates cash inflows that are largely independent of the cash inflows from other assets or groups
of assets.
Goodwill
The existence of cash-generating units may be particularly relevant to goodwill acquired in a
business combination. Purchased goodwill must be reviewed for impairment annually, and the
value of goodwill cannot be estimated in isolation. Often, goodwill relates to a whole business.
It may be possible to allocate purchased goodwill across several cash-generating units. If allocation
is not possible, the impairment review is carried out in two stages:
1 Carry out an impairment review on each of the cash-generating units (excluding the goodwill)
and recognise any impairment losses that have arisen.
2 Then carry out an impairment review for the entity as a whole, including the goodwill.
This is explained in more detail in Chapter 1: Business combinations and consolidation
(Section5.2).

2.2 Allocating an impairment loss

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

Example: Allocation of impairment loss in cash-generating unit

A cash-generating unit is made up of the following assets.

Rs. m
Property, plant and equipment 90
Goodwill 10
Other assets 60
160

© Emile Woolf International 446 The Institute of Chartered Accountants of Pakistan

 Chapter 20: Impairment of assets

The recoverable amount of the cash-generating unit has been assessed as Rs. 140 million.
The impairment loss would be allocated across the assets of the cash-generating unit as follows:

There is a total impairment loss of Rs. 20 million (= Rs. 160m – Rs. 140m). Of this, Rs. 10 million
is allocated to goodwill, to write down the goodwill to Rs. 0. The remaining Rs. 10 million is then
allocated to the other assets pro-rata.
Therefore:
Rs. 6 million (= Rs. 10m × 90/150) of the impairment loss is allocated to property, plant and
equipment, and
Rs. 4 million (= Rs. 10m × 60/150) of the loss is allocated to the other assets in the unit.
The allocation has the following result:

Before Impairment After loss

loss loss
Rs. m Rs. m Rs. m
Property, plant and equipment 90 (6) 84
Goodwill 10 (10) 
Other assets 60 (4) 56
160 (20) 140

© Emile Woolf International 447 The Institute of Chartered Accountants of Pakistan

Advanced accounting and financial reporting

3 OTHER ISSUES
Section overview

 Reversal of an impairment loss

 IFRIC 10: Interim financial reporting and impairment
 IAS 36 disclosure requirements

3.1 Reversal of an impairment loss

A company must make an assessment at the end of each reporting period as to whether a
previously recognised impairment should be decreased or may no longer exist. If the loss no longer
exists, it is reversed subject to the following guidance.
Any reversal should not lead to a carrying amount in excess of what the carrying amount of the
asset would have been without the recognition of the original impairment loss.
In allocating a reversal of an impairment loss, the carrying amount of an asset must not be
increased above the lower of:
 its recoverable amount (if determinable); and
 the carrying amount that would have been determined (net of amortisation or depreciation)
had no impairment loss been recognised for the asset in prior periods.
A reversal should be:
 recognised immediately in profit or loss; unless
 the original impairment was charged to the revaluation surplus, in which case the reversal
should be credited to the revaluation surplus (and reported in the same way as a revaluation
in ‘other comprehensive income’ for the period).
Depreciation charges for future periods should be adjusted to allocate the asset’s revised carrying
amount, minus any residual value, over its remaining useful life.
An impairment loss that has arisen on purchased goodwill cannot be reversed. This is because
any reversal of an impairment loss to goodwill is likely to be caused by an increase in internally-
generated goodwill rather than a reversal of the impairment of purchased goodwill. Internally-
generated goodwill must not be reported as an asset.

Example: Reversal of impairment loss

1st January Year 1
An asset was purchased at a cost of Rs. 100,000 and is being written off over 10 years on a
straight line basis. Annual depreciation is Rs. 10,000 per annum.
31st December Year 2
The asset has a carrying amount of Rs. 80,000 (Rs. 100,000 – (2 years  Rs. 10,000).
There are indications that the asset is impaired and its recoverable amount is estimated at Rs.
64,000. The resultant impairment loss of Rs. 16,000 is recognised.
The carrying amount of the asset after the recognition of the impairment loss (Rs. 64,000) is
written off over the remaining useful life of 8 years resulting in an annual depreciation charge of
Rs. 8,000.
31st December Year 4
The carrying amount of the asset is Rs. 48,000 (Rs. 64,000 – (2 years  Rs. 8,000).
There are indications that the impairment loss might have decreased and the company
estimates the recoverable amount of the asset to be Rs. 70,000.

© Emile Woolf International 448 The Institute of Chartered Accountants of Pakistan

 Chapter 20: Impairment of assets

Example: (continued)

This implies a reversal of Rs. 22,000 (Rs. 70,000 – Rs. 48,000).

However, the carrying amount of the asset cannot be increased to above what it would have
been had no impairment loss been recognised in the first place. This is an amount of Rs. 60,000
(Rs. 100,000 – (4 years  Rs. 10,000).
Therefore a reversal of Rs. 12,000 is recognised.
The carrying amount of the asset after the recognition of the reversal of the impairment loss (Rs.
60,000) is written off over the remaining useful life of 6 years resulting in an annual depreciation
charge of Rs. 10,000.

Reversal of impairment of a cash-generating unit

A reversal of an impairment loss for a cash-generating unit must be allocated to the assets of the
unit (except for goodwill) on a pro rata basis.
These increases in carrying amounts must be treated as reversals of impairment losses for
individual assets.
3.2 IFRIC 10: Interim financial reporting and impairment
Background
IAS 34 requires application of the same accounting policies in interim financial statements as are
applied in annual financial statements and states that “the frequency of an entity’s reporting
(annual, half-yearly, or quarterly) shall not affect the measurement of its annual results”.
It also requires that measurement for interim reporting purposes must be made on a year-to-date
basis.
An impairment loss on goodwill recognised in the interim financial statements might not have been
recognised at the next year end (due to change in circumstances).
 IAS 34 would seem to require reversal; but
 IAS 36 prohibits reversal.
The issue
Should an impairment loss on goodwill recognised in an interim period, be reversed if a loss would
not have been recognised (or a smaller loss would have been recognised) if the assessment had
been made only at a subsequent reporting date?
Consensus
An impairment loss recognised in previous interim period should not be reversed in respect of
goodwill.
The impairment principle overrides the interim measurement rule.

Example: IFRIC 10: Interim financial reporting and impairment

Entity X is a listed company that is required to produce quarterly financial statements in accordance
with IAS 34.
End of Q1
There were indications of impairment of one of Entity X’s cash-generating units (CGU).
The carrying amount of the CGU was Rs. 120,000 including goodwill of Rs. 30,000).
The recoverable amount of the CGU was estimated to be Rs. 100,000.
Therefore, an Impairment of Rs. 20,000 was booked in the Q1 financial statements. This was
allocated to goodwill included within the CGU.

© Emile Woolf International 449 The Institute of Chartered Accountants of Pakistan

Advanced accounting and financial reporting

Example: IFRIC 10: Interim financial reporting and impairment (continued)

End of Q4 (year-end)
At the year-end the recoverable amount is unchanged at Rs. 100,000.
The carrying amount of the CGU that would have been determined if no impairment had been
booked in Q1 was Rs. 90,000 (accounting for depreciation charge for the three quarters).
Therefore, if interim financial statements had not been prepared at Q1 and the impairment test
was carried out for the purpose of preparing the annual financial statements there would be no
impairment loss.
Application of the IAS 34 (year-to-date) approach would suggest reversal of the loss previously
recognised. However since that impairment was allocated to goodwill, the impairment loss cannot
be reversed.

3.3 IAS 36 disclosure requirements

For all impairments, the following disclosures should be made:
 The amount of impairment losses recognized or reversed for each class of assets or
reportable segment.
 The amount of impairment losses on revalued assets that have been recognised or
reversed.
 If the recognition or reversal of an individual impairment loss (including goodwill) or a
cash-generating unit, is material to the financial statements, there should be additional
disclosure of:
 the events and circumstances that led to the recognition or reversal of the impairment
loss.
 the amount of the impairment loss recognised or reversed.
 Nature and segment of the individual asset
 Description, amount of impairment loss (reversal) of cash generating unit by class of assets
and segment.
 Description of the current and former way of aggregating assets and the reasons for
changing the way the CGU is identified, if aggregation method has changed.
 Whether the recoverable amount is fair value less costs of disposal or value in use, and how
the figure for the recoverable amount was calculated.
 If the recoverable amount is fair value less costs of disposal:
 the level of the fair value hierarchy (from IFRS 13 Fair Value Measurement) within which
the fair value measurement is categorized;
 the valuation techniques used to measure fair value less costs of disposal;
 the key assumptions used in the measurement of fair value measurements categorised
within 'Level 2' and 'Level 3' of the fair value hierarchy; and
 the discount rate used in the current and previous measurement if fair value less cost of
disposal is measured using a present value technique.
 If impairment losses recognised (reversed) are material in aggregate to the financial
statements as a whole, disclose:
 main classes of assets affected
 main events and circumstances
 Disclose detailed information about the estimates used to measure recoverable amounts of
cash generating units containing goodwill or intangible assets with indefinite useful lives.

© Emile Woolf International 450 The Institute of Chartered Accountants of Pakistan

 Chapter 20: Impairment of assets

SOLUTIONS TO PRACTICE QUESTIONS

Solution 1
On 31 December Year 3 the machine was stated at the following amount:
a) Carrying amount of the machine on 31 December Year 3 Rs
Cost 240,000
Accumulated depreciation (3 × (240,000 ÷ 20 years)) (36,000)
Carrying amount 204,000
b) Impairment loss at the beginning of Year 4 of Rs. 104,000 (Rs. 204,000 – Rs.
100,000). This is charged to profit or loss.

c) Depreciation charge in Year 4 of Rs. 10,000 (= Rs. 100,000 ÷ 10). The depreciation
charge is based on the recoverable amount of the asset.

Solution 2
a) Carrying amount on Rs.
Cost 240,000
Accumulated depreciation at 1 January Year 3
(2 years × (240,000 ÷ 20)) (24,000)
Carrying amount 216,000
Valuation at 1 January Year 3 250,000
Revaluation surplus 34,000
b) When the asset is revalued on 1 January Year 3, depreciation is charged on the revalued
amount over its remaining expected useful life.
On 31 December Year 3 the machine was therefore stated at:
Rs.
Valuation at 1 January (re-valued amount) 250,000
Accumulated depreciation in Year 3 (= Rs. 250,000 ÷ 18)) (13,889)
Carrying amount 236,111
Note: The depreciation charge of Rs. 13,889 is made up of Rs. 12,000 (being that part of the
charge that relates to the original historical cost) and Rs. 1,889 being the incremental
depreciation.
Rs. 1,889 would be transferred from the revaluation surplus into retained earnings.
c) On 1 January Year 4 the impairment review shows an impairment loss of Rs. 136,111 (Rs.
236,111 – Rs. 100,000).
An impairment loss of Rs. 32,111 (Rs. 34,000  Rs. 1,889) will be taken to other
comprehensive income (reducing the revaluation surplus for the asset to zero).
The remaining impairment loss of Rs. 104,000 (Rs. 136,111  Rs. 34,000) is recognised in
the statement of profit or loss for Year 4.
d) Year 4 depreciation charge is Rs. 10,000 (Rs. 100,000 ÷ 10 years).

© Emile Woolf International 451 The Institute of Chartered Accountants of Pakistan

Advanced accounting and financial reporting

© Emile Woolf International 452 The Institute of Chartered Accountants of Pakistan

 Certified Finance and Accounting Professional

21

CHAPTER
Advanced accounting and financial reporting

Sundry standards

Contents
1 IFRS 6: Exploration for and evaluation of mineral resources
2 IFRS 14: Regulatory deferral accounts

© Emile Woolf International 453 The Institute of Chartered Accountants of Pakistan

Advanced accounting and financial reporting

1 IFRS 6: EXPLORATION FOR AND EVALUATION OF MINERAL RESOURCES

Section overview

 Objective and Scope

 Selection of accounting policies
 Initial recognition and measurement
 Subsequent measurement
 Presentation
 Impairment
 Disclosure

1.1 Objective and Scope

IFRS 6 specifies the financial reporting for the exploration for and evaluation of mineral
resources. In particular, the IFRS requires:
(a) limited improvements to existing accounting practices for exploration and evaluation
expenditures.
(b) entities that recognise exploration and evaluation assets to assess such assets for
impairment in accordance with IAS 36.
(c) disclosures that identify and explain the amounts in the entity’s financial statements arising
from the exploration for and evaluation of mineral resources and help users of those
financial statements understand the amount, timing and certainty of future cash flows from
any exploration and evaluation assets recognised.
IFRS 6 applies to expenditure incurred on exploration for and evaluation of mineral resources but
not to those expenditures incurred:
 before the exploration for and evaluation of mineral resources (e.g. expenditures incurred
before the entity has obtained the legal rights to explore a specific area); or
 after the technical feasibility and commercial viability of extraction are demonstrable

Definitions
Exploration and evaluation assets are exploration and evaluation expenditures recognised as
assets in accordance with the entity’s accounting policy.
Exploration and evaluation expenditures are expenditures incurred by an entity in connection with
the expenditures for and evaluation of mineral resources before the technical feasibility and
commercial viability of extracting a mineral resource are demonstrable.

1.2 Selection of accounting policies

IAS 8 sets out criteria which must be applied by a company when needs to develop an accounting
policy for a transaction not covered by a specific IFRS.
IFRS 6 exempts companies from applying these criteria in developing an accounting policy for the
recognition and measurement of exploration and evaluation assets.
In other words, companies are free to develop an accounting policy (within the broader guidance
of IFRS 6) without reference to other parts of IFRS. This is particularly useful when a company
involved in this industry adopts IFRS because they may be able to carry on using their pre IFRS
accounting policy

© Emile Woolf International 454 The Institute of Chartered Accountants of Pakistan

 Chapter 21: Sundry standards and interpretations

Changes in accounting policies

An entity is allowed to change accounting policies for exploration and evaluation expenditures
when the change makes information used as a basis of decision making:
 more relevant and no less reliable; or
 more reliable and no less relevant
To justify a change, the company must demonstrate that the change brings the financial statements
closer to meeting the IAS 8 criteria but the change need not achieve full compliance with those
criteria

1.3 Initial recognition and measurement

Exploration and evaluation assets are measured at cost.
Elements of cost
A company must determine a policy of specifying which expenditures are recognised as exploration
and evaluation assets and apply this policy consistently in doing this.
Following are examples of expenditures which might be included in the initial measurement (the
list is not exhaustive):
 acquisition of exploration rights;
 topographical, geological, geochemical and geophysical studies;
 exploratory drilling;
 trenching;
 sampling; and
 activities in relation to evaluating the technical feasibility and commercial viability of
extracting a mineral resource
Expenditures related to the development of mineral resources must not be recognised as
exploration and evaluation assets. The Conceptual Framework and IAS 38 Intangible Assets
provide guidance on the recognition of assets arising from development.
IAS 37 applies to the recognition of any obligations for removal and restoration that are incurred
as a consequence of exploration for and evaluation of mineral resources.
1.4 Subsequent measurement
A company must apply one of the following to exploration and evaluation assets:
 cost model; or
 revaluation model
If the revaluation model is applied (IAS 16 or IAS 38 model), it must be consistent with the
classification of the expenditure as tangible or intangible
This means that a revaluation model for expenditure classified as an intangible is only possible if
there is a fair value that can be measured with reference to an active market

1.5 Presentation
Exploration and evaluation assets must be classified according to the nature of the assets acquired
as:
 tangible (e.g. vehicles and drilling rigs); or
 intangible (e.g. drilling rights).
The classification must be applied consistently.

© Emile Woolf International 455 The Institute of Chartered Accountants of Pakistan

Advanced accounting and financial reporting

An exploration and evaluation asset is reclassified from this category when the technical feasibility
and commercial viability of extracting a mineral resource are demonstrable. In such cases they
must be assessed for impairment before reclassification.

1.6 Impairment
Exploration and evaluation assets must be:
 allocated to cash-generating units (CGUs) or groups of CGUs for the purpose of assessing
such assets for impairment (the CGU; and
 assessed for impairment when there are indications that the carrying amount may exceed
recoverable amount
Exploration and evaluation assets are unlikely to generate cash flows independently from other
assets so as such they are similar to goodwill. Therefore IFRS 6 requires them to be allocated to
CGUs groups for the purpose of impairment testing. They are not tested individually for impairment
Indicators of impairment include (the list is not exhaustive):
 expiry of the period of the exploration right without expectation of renewal;
 expenditure on further exploration/evaluation in the specific area previously not
budgeted/planned;
 non discovery of commercially viable quantities of mineral resources;
 a decision to discontinue activities in the specific area;
 indication that the carrying amount of the exploration and evaluation asset is unlikely to be
recovered in full from successful development or by sale
1.7 Disclosure
Entities must disclose information that identifies and explains the amounts recognised arising from
the exploration and evaluation of mineral resources. To fulfill this requirement, an entity shall
disclose:
 accounting policies for exploration and evaluation expenditures, and recognition as assets;
 amounts of assets, liabilities, income and expense and operating and investing cash flows
arising from the exploration for and evaluation of mineral resources
 Exploration and evaluation assets must be treated as a separate class of assets (IAS 16 or
IAS 38 disclosures apply depending on classification).

© Emile Woolf International 456 The Institute of Chartered Accountants of Pakistan

 Chapter 21: Sundry standards and interpretations

2 IFRS 14: REGULATORY DEFERRAL ACCOUNTS

Section overview

 Introduction
 Key features

2.1 Introduction
Some countries regulate prices that can be charged for certain goods and services. Such goods
and services are said to be “rate regulated”. For example, National Refinery petroleum products
selling prices to be charged to Oil Marketing Companies (e.g. PSO) are regulated by OGRA (Oil
and Gas Regulatory Authority of Pakistan)

Definitions
Rate-regulated activities: An entity’s activities that are subject to rate regulation.
Rate regulation: A framework for establishing the prices that can be charged to customers for
goods or services and that framework is subject to oversight and/or approval by a rate regulator.
Regulatory deferral account balance: The balance of any expense (or income) account that would
not be recognised as an asset or a liability in accordance with other Standards, but that qualifies
for deferral because it is included, or is expected to be included, by the rate regulator in establishing
the rate(s) that can be charged to customers.

2.2 Key features

Below are some of the key features of this interim standard:
(a) It allows (but does not require) an entity whose activities are subject to rate regulation to
continue applying most of its existing accounting policies for regulatory deferral account
balances upon first-time adoption of IFRS.
(b) Existing IFRS preparers are prohibited from applying this standard.
(c) Entities that adopt this standard must present the regulatory deferral accounts as separate
line items in the statement of financial position and present movements in these account
balances as separate line items in the statement of profit or loss and other comprehensive
income (OCI).
(d) The standard requires disclosures on the nature of, and risks associated with, the entity’s
rate regulation and the effects of that rate regulation on its financial statements.
(e) If the standard is applied, full retrospective application is required.
IFRS 14 is an optional standard that is intended to encourage rate-regulated entities to adopt IFRS
while bridging the gap with similar entities that already apply IFRS, but which do not recognise
regulatory deferral accounts. This would be achieved by requiring separate presentation of the
regulatory deferral account balances (and movements in these balances) in the statement of
financial position and statements of profit or loss and other comprehensive income.

© Emile Woolf International 457 The Institute of Chartered Accountants of Pakistan

Advanced accounting and financial reporting

© Emile Woolf International 458 The Institute of Chartered Accountants of Pakistan

 Certified Finance and Accounting Professional

22

CHAPTER
Advanced accounting and financial reporting

IFRS 1: First time adoption of IFRS

Contents
1 Accounting for the transition to IFRS
2 Presentation and disclosure

© Emile Woolf International 459 The Institute of Chartered Accountants of Pakistan

Advanced accounting and financial reporting

1 ACCOUNTING FOR THE TRANSITION TO IFRS

Section overview

 Introduction and terminology

 Opening IFRS statement of financial position
 Full retrospective application of IFRS
 Permitted exceptions to full retrospective application of other IFRS
 Mandatory exceptions to full retrospective application of IFRS

1.1 Introduction and terminology

Changing from one GAAP to another is a major undertaking which has wide reaching implications
for the company undertaking this step.
IFRS 1 First Time Adoption of International Financial Reporting Standards explains how the
transition to IFRS should be accounted for.
The application of this IFRS is limited to the entities that are:
1. Newly incorporated companies during the year that will make financial statements as per IFRS
or
2. Existing companies which prepared their financial statements using GAAP or other local
accounting standards that intends to or is required to issue IFRS complaint financial
statements.

Definitions
First time adopter:
An entity that presents its first IFRS financial statements
First IFRS financial statements:
The first annual financial statements in which an entity adopts IFRS by an explicit and unreserved
statement of compliance with IFRS.

The first IFRS financial statements will include the current year, which is the first period published
entirely according to IFRS and comparatives, which were originally published under previous
GAAP, and have been restated into IFRS.
A first-time adopter must prepare an opening statement of financial position according to IFRS as
at the date of transition to IFRS.

Definitions
Date of transition to IFRSs:
The beginning of the earliest comparative period for which an entity presents full comparative
information under IFRS in its first IFRS financial statements.
Opening IFRS statement of financial position:
An entity’s statement of financial position at the date of transition to IFRSs.

The opening IFRS statement of financial position is prepared by full retrospective application of all
IFRS extant at the end of first IFRS reporting period.

Definition
First IFRS reporting period:
The latest reporting period covered by the entity’s first IFRS financial statements.

© Emile Woolf International 460 The Institute of Chartered Accountants of Pakistan

 Chapter 22: IFRS 1: First time adoption of IFRS

Example: Terminology
A company is preparing its first IFRS financial statements for the year ending 31 December 20X6.
The company operates in a regime that requires a single period of comparative information.
First IFRS reporting period Year ended 31 December 20X6
First IFRS financial statements: Financial statements prepared to the above year-end
All IFRSs extant at this date are applied retrospectively
(subject to permitted exemptions and mandatory
exceptions).
Date of transition to IFRSs 1 January 20X5 (the start of the comparative period)
Opening IFRS statement of An IFRS statement of financial position prepared as at the
financial position: above date. (1 January 20X5)

1.2 Opening IFRS statement of financial position

As stated above, the opening IFRS statement of financial position is prepared by full retrospective
application (subject to permitted exemptions and mandatory exceptions) of all IFRS extant at the
first IFRS reporting date. The standards extant at the reporting date are used to reconstruct the
statement of financial position as at the date of transition. This means that if a rule in existence at
the date of transition was changed by the first IFRS reporting date, it is the new rule that is applied
in building the opening IFRS statement of financial position.
The opening IFRS statement of financial position becomes the basis for accounting moving
forward. It is constructed at the start of the comparative period. The company will already have
prepared and filed financial statements for this period under its previous GAAP. These have to be
restated to IFRS to become the IFRS comparatives to the first IFRS financial statements.

Example: Terminology
A company is preparing its first IFRS financial statements for the year ending 31 December 20X8.
The company operates in a regime that requires a single period of comparative information.
The company drafts its opening IFRS statement of financial position as at 1 January 20X7.
It will have published financial statements under its previous GAAP to cover the year end 31
December 20X7.
These are restated to become comparatives in the first IFRS financial statements.

1.3 Full retrospective application of IFRS

Full retrospective restatement means that all of the figures from the previous GAAP statement of
financial position should be restated to what they would have been if IFRS had always been
applied.
This means that in the opening IFRS statement of financial position, a first-time adopter must:
 recognise all assets and liabilities whose recognition is required by IFRSs;
 not recognise assets or liabilities if IFRSs do not permit such recognition;
 re-classify items recognised under the previous GAAP as one type of asset, liability or
component of equity if IFRSs require that they should be classified differently; and
 apply IFRSs in measuring all assets and liabilities.
These adjustments are made at the date of transition and lead to restructuring of the comparative
statement of financial position
Full retrospective restatement is a difficult task. IFRS must be applied in its entirety from the date
of transition but there are two categories of exception to full retrospective restatement before this.
These are:
 exemptions which are permitted; and
 exceptions which are mandatory.

© Emile Woolf International 461 The Institute of Chartered Accountants of Pakistan

Advanced accounting and financial reporting

1.4 Permitted exceptions to full retrospective application of other IFRS

A first-time adopter may apply the following exceptions:
 business combinations;
 cost of non-current assets (deemed cost);
 cumulative translation differences;
 investments in subsidiaries, associates and jointly controlled entities (IAS 27); and
 designation of previously recognised financial instruments.
Business combinations
The “business combination” exemption is actually a series of exemptions relating to:
 IFRS 3: Business combinations;
 Consolidation, equity accounting and joint arrangements (IFRS 10, IFRS 11 and IAS 28);
 IAS 21: The effects of Changes in Foreign Exchange Rates
The rules on business combinations must be applied to all transactions arising after the date of
transition but do not have to be applied retrospectively.
However, IFRS 1 allows the rules to apply from any date before the date of transition. In effect, this
means that a company could pick any date before the date of transition from which to start applying
IFRS and if this is the case both IFRS 3 and IFRS 10 must be applied to all subsequent
combinations.
Alternative rules apply if IFRS 3 is not applied retrospectively (Appendix C to IFRS 1). These
include:
 assets and liabilities recognised under previous GAAP forms the basis for the recognition of
assets and liabilities under IFRS at the date of transition (subject to adjustments);
 the carrying amount of assets and liabilities under previous GAAP is deemed cost for IFRS;
 goodwill written off is not reinstated;
 goodwill at transition is subject to impairment test.
IAS 21 requires that goodwill and fair value adjustments arising on acquisition of a foreign operation
are retranslated at each reporting date. IFRS 1 allows that this requirement does not have to be
applied to business combinations before the date of transition.
Deemed cost
This exemption applies to:
 Property, plant and equipment;
 Intangible assets (conditions apply);
 Investment property; and
 Exploration and evaluation assets for oil and gas under IFRS 6, and assets recorded in
respect of rate-regulated activities
It might be difficult to retrospectively construct the IFRS cost of non-current assets at the date of
transition.
IFRS 1 allows the use of one of the following to establish the IFRS cost of an asset at the date of
transition:
 fair value;
 cost adjusted by changes in an inflation index;
 a fair value established at a date before the date of transition in accordance with previous
GAAP;
 cost as determined under previous GAAP (oil and gas, rate-regulated activities).

© Emile Woolf International 462 The Institute of Chartered Accountants of Pakistan

 Chapter 22: IFRS 1: First time adoption of IFRS

Cumulative translation differences

IAS 21 requires cumulative translation differences (CTDs) arising on translation of foreign
operations to be classified as a separate component of equity and recycled through the statement
of profit or loss on disposal of the subsidiary.
A first time adopter does not have to identify CTDs that arose before the date of transition
Investments in subsidiaries, jointly controlled entities and associates
If an entity prepares separate financial statements IAS 27 Separate Financial Statements requires
it to account for investments in subsidiaries, jointly ventures and associates either:
 at cost;
 in accordance with IFRS 9; or
 using the equity method as described in IAS 28
IFRS 1 allows one of the following amounts to be used to establish a cost for IFRS in the separate
opening IFRS financial statements:
 cost determined in accordance with IAS 27; or
 deemed cost. The deemed cost shall be its:
i. fair value at the date of transition; or
ii. previous GAAP carrying amount at that date
Designation of previously recognised financial instruments
IFRS 9 Financial Instruments allows classification on initial recognition of:
 a financial asset at amortised cost, fair value through other comprehensive income or fair
value through profit or loss (conditions); and
 a financial liability as fair value through profit or loss (conditions)
IFRS 1 allows such designation to be made at the date of transition
1.5 Mandatory exceptions to full retrospective application of IFRS
IFRS 1 prohibits the retrospective application of some IFRSs for the opening IFRS statement of
financial position.
Exceptions that must be used concern the following:
 estimates;
 derecognition of financial assets and liabilities;
 hedge accounting;
 non-controlling interests;
 embedded derivatives; and
 government loans
Estimates
An entity must not apply hindsight to estimates at the date of transition (unless there is evidence
that they were wrong)
The statement of financial position at the date of transition and restated comparatives must be
constructed using estimates current as at those dates
Estimates might include:
 market values;
 exchange rates;
 interest rates;

© Emile Woolf International 463 The Institute of Chartered Accountants of Pakistan

Advanced accounting and financial reporting

Example: Estimates
A company is preparing its first IFRS financial statements for the year ending 31 December 20X8.
The company operates in a regime that requires a single period of comparative information. This
means that its date of transition is 1 January 20X7.
The company had recognised a warranty provision in its previous GAAP financial statements for the
year ended 31 December 20X6.
This provision was based on an expectation that 5% of products would be returned.
During 20X7 and 20X8, 7% of products were returned.
The opening IFRS statement of financial position includes a provision recognised and measured in
accordance with IAS 37. This provision is based on estimated returns of 5% as this was the estimate
current at that date.
The company is not allowed to base the measurement of the provision on 7% returns.

Derecognition
If an asset was derecognised under previous GAAP but would not have been under IFRS, full
retrospective application would bring it back onto the statement of financial position. This is not
allowed by IFRS 1.
The IFRS 9 derecognition rules must be applied prospectively for transactions occurring on or after
the date of transition to IFRSs.
 non-derivative financial assets and liabilities derecognised in a period beginning before
transition are not re-recognised; however
 an entity may apply the rules retrospectively from any date of its choosing but only if the
information needed to apply IFRS 9 was obtained at the date of the transaction.
Note that some financial assets that were derecognised before the date of transition might still be
brought back onto the opening IFRS statement of financial position due to the rules requiring
consolidation of special purpose vehicles. If a financial asset had been derecognised in a sale or
transfer to an entity which would be defined as a subsidiary under IFRS, that financial asset would
be brought back into the opening IFRS statement of financial position by consolidation.
Hedge accounting
Hedge accounting relationships cannot be designated retrospectively
At transition;
 all derivatives are measured at fair value;
 deferred gains/losses previously reported as assets and liabilities are eliminated;
 hedge accounting can only be used if the hedge qualifies under rules in IFRS.
Non-controlling interests
IFRS 10 contains rules:
 on accounting for changes in ownership of a subsidiary that do and do not result in a loss of
control; and
 that require total comprehensive income to be attributed to the parent and to the non-
controlling interests even if this results in the non-controlling interests having a deficit
balance;
These rules must be applied prospectively from the date of transition
If a first-time adopter elects to apply IFRS 3 retrospectively to past business combinations, it must
also apply IFRS 10 from the same date

© Emile Woolf International 464 The Institute of Chartered Accountants of Pakistan

 Chapter 22: IFRS 1: First time adoption of IFRS

2 PRESENTATION AND DISCLOSURE

Section overview

 Presentation by a first time adopter

 Disclosure by a first time adopter

2.1 Presentation by a first time adopter

IFRS 1 requires that a first-time adopter must include at least one year of comparative information
in its first IFRS financial statements. (This is why the date of transition to IFRS cannot be later than
the beginning of the previous financial year).
To comply with IAS 1, the first IFRS financial statements must include at least:
 Three statements of financial position:
 Current year (the date to which the first IFRS financial statements are prepared);
 Last year (the comparatives to the first IFRS financial statements which were originally
published under the previous GAAP);
 Start of last year (date of transition).
 Two statements of profit and loss and other comprehensive income (current year with
comparatives);
 Two statements of cash flows (current year with comparatives);
 Two statements of changes in equity (current year with comparatives); and
 Two sets of related notes to the financial statements (current year with comparatives).
2.2 Disclosure by a first-time adopter
The company must explain how the transition to IFRS affected its reported:
 financial position;
 financial performance; and
 cash flows.
IFRS 1 requires that a company publish reconciliations of amounts in the previous GAAP financial
statements to those in the IFRS financial statements.
The first IFRS financial statements must include:
 reconciliations of equity (net assets):
 at the date of transition; and
 at the end of latest period presented under previous GAAP;
 a reconciliation of the profit or loss for the latest period presented under previous GAAP

© Emile Woolf International 465 The Institute of Chartered Accountants of Pakistan

Advanced accounting and financial reporting

Illustration: Reconciliations

SoFP = Statement of financial position

Total CI = Total comprehensive income

IFRS 1 provides an illustrative example in columnar form.

The adjustment to each previous GAAP figure must be explained in notes to the financial
statements.
A simple example follows to show the presentation for the reconciliation of net equity.

Example: Reconciliation of equity

A simplified example of a reconciliation of equity is shown below.
Previous IFRS
GAAP adjustments IFRSs
Rs. Rs. Rs.
Property, plant and equipment 2,000 300 2,300
Intangible assets 400 (50) 350
Total non-current assets 2,400 250 2,650
Trade and other receivables 1,200 0 1,200
Inventory 800 (70) 730
Cash 50 0 50
Total current assets 2,050 (70) 1,980
Total assets 4,450 180 4,630
Loans 800 0 800
Trade payables 415 0 415
Current tax liability 30 0 30
Deferred tax liability 25 220 245
Total liabilities 1,270 220 1,490
Total assets less total liabilities 3,180 (40) 3,140

Issued capital 1,000 0 1,000

Revaluation reserve 0 190 190
Retained earnings (balance) 2,180 (230) 1,950
Total equity 3,180 (40) 3,140

© Emile Woolf International 466 The Institute of Chartered Accountants of Pakistan

 Certified Finance and Accounting Professional

23

CHAPTER
Advanced accounting and financial reporting

Specialised financial statements

Contents
1 IFRS for small and medium sized entities (SMEs)
2 Insurance companies
3 Banks
4 Mutual funds
5 IAS 26: Retirement benefit plans

© Emile Woolf International 467 The Institute of Chartered Accountants of Pakistan

Advanced accounting and financial reporting

1 IFRS FOR SMALL AND MEDIUM-SIZED ENTITIES (SMEs)

Section overview

 Introduction
 IFRS for SMEs
 Key differences between IFRS for SMEs & full IFRS

1.1 Introduction
International accounting standards are written to meet the needs of investors in international capital
markets. Most companies adopting IFRSs are listed entities. The IASB has not stated that IFRSs
are only aimed at quoted companies, but certainly the majority of adopters are large entities. In
many countries IFRSs are used as national GAAP which means that unquoted small and medium-
sized entities (SMEs) have to apply them. SMEs are defined as entities that do not have public
accountability* and publish general purpose financial statements for external users.
An entity has public accountability* if:
(a) its debt or equity instruments are traded in a public market or it is in the process of issuing
such instruments for trading in a public market; or
(b) it holds assets in a fiduciary capacity for a broad group of outsiders as one of its primary
businesses (most banks, insurance companies, securities brokers/dealers, mutual funds
and investment banks would meet this second criterion).
The users of financial statements of SMEs are different from the users of the general purpose
financial statements. The only ‘user groups’ that use the financial statements of an SME are
normally:
 its owners who are not involved in managing the business;
 existing and potential creditors and
 credit rating agencies.
The SME is often owned and managed by a small number of entrepreneurs, and may be a family-
owned and family-run business. Large companies, in contrast, are run by professional boards of
directors, who must be held accountable to their shareholders.
Considerations in developing standards for SMEs
The aim of developing a set of accounting standards for SMEs is that they allow information to be
presented that is relevant, reliable, comparable and understandable. The information presented
should be suitable for the uses of the managers and directors and any other interested parties of
the SME.
Additionally, many of the detailed disclosures within full IFRSs are not relevant and the accounting
standards should be modified for this. The difficulty is getting the right balance of modification, too
much and the financial statements will lose their focus and will not be helpful to users.
1.2 IFRS for SMEs
The currently applicable IFRS for SMEs was issued by IASB in May 2015. It is a small Standard
(approximately 250 pages) that is tailored for small companies. While based on the principles in
full IFRS Standards, the IFRS for SMEs Standard is stand-alone. It is organised by topic. The IFRS
for SMEs Standard reflects five types of simplifications from full IFRS Standards:
 Some topics in full IFRS Standards are omitted because they are not relevant to typical
SMEs;
 Some accounting policy options in full IFRS Standards are not allowed because a more
simplified method is available to SMEs;

© Emile Woolf International 468 The Institute of Chartered Accountants of Pakistan

 Chapter 23: Specialised financial statements

 Many of the recognition and measurement principles that are in full IFRS Standards have
been simplified;
 Substantially fewer disclosures are required; and
 The text of full IFRS Standards has been redrafted in ‘simple English’ for easier
understandability and translation.
The IFRS for SMEs does not address the following topics:
 earnings per share (i.e. there is no equivalent to IAS 33);
 interim accounting (i.e. there is no equivalent to IAS 34);
 segment reporting (i.e. there is no equivalent to IFRS 8);
The omission of equivalent rules to those in IAS 33, IAS 34 and IFRS 8 is not surprising as they
are only relevant to listed entities.
Stand-alone document
The IFRS for SMEs is a stand-alone document. This means that it contains all of the rules to be
followed by SMEs without referring to other IFRSs. For example it sets out rules for property, plant
and equipment without specifying that the rules are similar or dissimilar to those found in IAS 16.
In the following pages, we provide an overview of the sections of the IFRS for SMEs and often
refer to similarity or difference to equivalent other IFRSs. This is not what the IFRS for SMEs does
but we adopt the approach to make it easier for you to gain an understanding of the main features
of the standard.
The IFRS for SMEs is derived from rules in other IFRS. You will note that it uses the same
terminology and that many of the rules are identical. However, in several cases, the rules in other
IFRSs from which the IFRS for SMEs derives have been changed whereas the equivalent rules in
this standard have not been changed. For example the rules on joint ventures are based on IFRS
11 which you covered earlier. You should not interpret this as meaning that the standard is out of
date. It simply means that there is a difference between the rules for SMEs and those followed by
other entities. Changes to the main body of standards will not necessarily result in a revision to the
IFRS for SMEs.
1.3 KEY DIFFERENCES BETWEEN IFRS FOR SMEs & FULL IFRS
The key differences between IFRS for SMEs and full IFRS are summarized below:
Financial statement presentation

IFRS for SMEs IFRS

Single statement of income and retained
earnings.
IFRS for SMEs require an entity to present the The IFRSs also require an entity to present the
statement of comprehensive income by either a statement of comprehensive income by either
single statement or two statement approach. a single statement or two statement
Additionally, IFRS for SMEs also permit an entity approach. However, IFRSs do not permit an
to present a combined statement of income and entity to present a combined statement of
retained earnings instead of the statement of income and retained earnings instead of the
comprehensive income and statement of changes statement of comprehensive income and
in equity when changes in equity during the period statement of changes in equity.
arise only from profit or loss, payment of
dividends, correction of prior period errors and
changes in accounting policy.
(IFRS for SMEs – 3.18)

© Emile Woolf International 469 The Institute of Chartered Accountants of Pakistan

Advanced accounting and financial reporting

IFRS for SMEs IFRS

Segment information
The IFRS for SMEs does not require segment The IFRSs require segment information to be
information to be presented in financial presented in financial statements.
statements.
Earnings per share
The IFRS for SMEs does not require earnings per The IFRSs require the entities covered in the
share to be disclosed in the financial statements. scope of IAS 33 ‘Earning per share’ to present
earnings per share in accordance with the
requirements of IAS 33.

Consolidated and separate financial statements

IFRS for SMEs IFRS

Combined financial statements

The IFRS for SMEs defines combined financial Full IFRSs do not include definition or
statements as a single set of financial statements principles for preparation of combined
of two or more entities controlled by a single financial statements.
investor. Although, the IFRS for SMEs does not
require combined financial statements to be
prepared, it does provide basic principles when an
entity voluntarily prepares combined financial
statements in compliance with the IFRS for SMEs.
(IFRS for SMEs – 9.28)

Change in accounting policy and retrospective restatements

IFRS for SMEs IFRS

Third balance sheet

IFRS for SMEs does not require presentation of When financial statements are restated
three statements of financial position when retrospectively, IFRSs require presentation of
financial statements are restated retrospectively. three statements of financial position.

Financial instruments

IFRS for SMEs IFRS

Scope
IFRS for SMEs distinguishes between basic and The IFRSs do not provide distinction between
complex financial instruments. Section 11 basic and complex financial instruments.
establishes measurement and reporting Accordingly, there are no separate
requirements for basic financial instruments; requirements for recognition and
Section 12 deals with complex financial measurement based on complexity of the
instruments. financial instruments.
If an entity enters into only basic financial
instruments transactions then section 12 is not
applicable.
(IFRS for SMEs – 11.1)

© Emile Woolf International 470 The Institute of Chartered Accountants of Pakistan

 Chapter 23: Specialised financial statements

IFRS for SMEs IFRS

Accounting policy choice

An entity has a choice of applying either:
 the requirements of both Sections 11 and 12 The IFRSs do not provide an accounting policy
of IFRS for SMEs in full; or choice for recognition and measurement of
 recognition and measurement requirements financial instruments.
of full IFRS (IAS 39) and disclosure
requirements of IFRS for SMEs under Sections
11 and 12.
(IFRS for SMEs – 11.2)

IFRS for SMEs IFRS

Hedge Accounting
IFRS for SMEs permits specific types of hedging Full IFRSs do not restrict hedge accounting for
that SMEs are likely to use and only allows hedge limited number of risks and hedging
accounting for limited number of risks and hedging instruments.
instruments.
Consequently, hedge accounting is not permitted
under IFRS for SMEs when hedge is done by using
debt instruments such as a foreign currency loan,
or an option- based hedging strategy.
(IFRS for SMEs – 12.17)

Disclosures
IFRS for SMEs does not require disclosures to IFRSs require disclosures to enable
enable evaluation of nature and extent of risks evaluation of nature and extent of risks
arising from financial instruments to which entity arising from financial instruments to which
is exposed at the end of the reporting period. entity is exposed at the end of the reporting
period.

Investment in associates and jointly controlled entities

IFRS for SMEs IFRS

Accounting policy choice for associates and jointly

controlled entities
IFRS for SMEs does not permit the cumulative
The IFRSs require investments in associates
amount of exchange differences relating to a
and jointly controlled entities to be accounted
foreign operation, that were previously recognised
for using the equity method in an investor’s
in other comprehensive income, from being
primary financial statements.
reclassified from equity to profit or loss (as a
reclassification adjustment) when the gain or loss
on disposal of foreign operation is recognised.
(IFRS for SMEs – 14.4 & 15.9)

© Emile Woolf International 471 The Institute of Chartered Accountants of Pakistan

Advanced accounting and financial reporting

Investment property

IFRS for SMEs IFRS

Measurement after initial recognition

Investment property whose fair value can be IFRS allow an accounting policy choice of
measure reliably without undue cost or effort shall either fair value through profit or loss or a
be measured at fair value at each reporting date. cost-depreciation-impairment model (with
All other investment property (whose fair value some limited exceptions). An entity following
cannot be measured reliably without undue cost the cost-depreciation-impairment model is
and effort) shall be measured using cost model. required to provide supplemental disclosure
(IFRS for SMEs - 16.7) of the fair value of its investment property.

Disclosures
Reconciliation of the carrying amount at the IFRS require comparative information in
beginning and end of the reporting period is not respect of previous period for reconciliation of
required for the prior period. the carrying amount at the beginning and end
(IFRS for SMEs – 16.10(e)) of the reporting period.

Property, plant and equipment

IFRS for SMEs IFRS

Disclosures
Reconciliation of the carrying amount at the IFRSs require comparative information in
beginning and end of the reporting period is not respect of previous period for reconciliation of
required for the prior period. the carrying amount at the beginning and end
(IFRS for SMEs – 17.31(e)) of the reporting period.

Non-current assets held for sale

IFRS for SMEs IFRS

Presentation and measurement

The IFRS for SMEs does not require a non-current The IFRSs require a non-current asset held for
asset held for sale to be recognized at the lower of sale (including the non-current assets of a
carrying amount or fair value less cost to sell and discontinued operation) to be carried at the
presented separately as in the statement of lower of its carrying amount and fair value
financial position. less estimated costs to sell the asset. A non-
current asset classified as held for sale and
the assets of a disposal group classified as
held for sale are required to be presented
separately from other assets in the statement
of financial position.

Intangible assets

IFRS for SMEs IFRS

Useful life and amortization

The intangible assets must have a determinable IFRSs require intangible assets with indefinite
useful life, whereas assets with indeterminable life to be carried at cost less impairment loss,
useful life are considered to have ten years of if any and such assets are not depreciated.
useful life.
(IFRS for SMEs – 18.19 & 18.20)

© Emile Woolf International 472 The Institute of Chartered Accountants of Pakistan

 Chapter 23: Specialised financial statements

IFRS for SMEs IFRS

Disclosures

Reconciliation of the carrying amount at the IFRSs require comparative information in

beginning and end of the reporting period is not respect of previous period for reconciliation of
required for the prior period. the carrying amount at the beginning and end
of the reporting period.
(IFRS for SMEs – 18.27(e))

Development expenditure

The development and research expenditures are IFRSs require development costs which meet
always recorded as an expense. the specified condition to be capitalized as an
asset.
(IFRS for SMEs – 18.14)

Business combination

IFRS for SMEs IFRS

Cost of a business combination

The cost of a business combination includes the The IFRSs excludes directly attributable costs
fair value of assets given, liabilities incurred or from the cost of a business combination and
assumed and equity instruments issued by the such costs are required to be recognized in
acquirer, in exchange for the control of the profit or loss when incurred.
acquiree, plus any directly attributable costs.

(IFRS for SMEs – 19.11)

Goodwill

After initial recognition, the goodwill is measured Under the IFRSs, the goodwill acquired in a
at cost less accumulated amortisation and any business combination is not amortised. It is
accumulated impairment losses. Goodwill is required to be subject to impairment testing
amortised over its useful life, which is presumed to at least annually and, additionally, when
be 10 years if the entity is unable to make a there is an indication of impairment
reliable estimate of the useful life.

(IFRS for SMEs – 19.23)

Provision and contingencies

IFRS for SMEs IFRS

Disclosures of provisions

IFRS for SMEs does not require an entity to IFRS require comparative information for the
disclose comparative information in the required previous period in the required disclosures for
disclosures for provisions. provisions.

(IFRS for SMEs – 21.14)

© Emile Woolf International 473 The Institute of Chartered Accountants of Pakistan

Advanced accounting and financial reporting

Government grants

IFRS for SMEs IFRS

Recognition
IFRS for SMEs does not require or permit an entity The IFRSs require government grants to be
to match the grant with the expenses for which it recognised as income over the periods
is intended to compensate or the cost of the asset necessary to match them with the related
that it is used to finance. costs for which they are intended to
(IFRS for SMEs – 24.4) compensate, on a systematic basis.

Measurement
All government grants, including non-monetary The IFRSs permit an entity that receives a
government grants, must be measured at the fair non-monetary grant to either measure both
value of the asset received or receivable. the asset and the grant at a nominal amount
(IFRS for SMEs – 24.5) (often zero) or at the fair value of the non-
monetary asset.
Borrowing costs

IFRS for SMEs IFRS

Recognition
All borrowing costs shall be recognised as an IFRSs require borrowing costs directly
expense in profit or loss. attributable to the acquisition, construction or
production of a qualifying asset to be
(IFRS for SMEs - 25.2)
capitalized as a part of the cost of the asset.
Employee benefits

IFRS for SMEs IFRS

Actuarial gains and losses

Actuarial gains and losses on liabilities are The IFRSs require recognition of actuarial
recognised in full in profit or loss or in other gains and losses for the reporting period in
comprehensive income (without recycling) in the the other comprehensive income.
period in which they occur.
(IFRS for SMEs – 28.24)

Foreign Currency Translation

IFRS for SMEs IFRS

Exchange differences relating to a foreign

operation
IFRS for SMEs does not permit the cumulative
The IFRSs require the cumulative amount of
amount of exchange differences relating to a
exchange differences relating to a foreign
foreign operation, that were previously recognised
operation, that were previously recognised in
in other comprehensive income, from being
other comprehensive income, from being
reclassified from equity to profit or loss (as a
reclassified from equity to profit or loss (as a
reclassification adjustment) when the gain or loss
reclassification adjustment) when the gain or
on disposal of foreign operation is recognised.
loss on disposal is recognised.
(IFRS for SMEs – 30.13)
Note: The students are advised to refer to the latest Financial Statements of SMEs for further
understanding of applicable formats.

© Emile Woolf International 474 The Institute of Chartered Accountants of Pakistan

 Chapter 23: Specialised financial statements

2 INSURANCE COMPANIES
Section overview

 Introduction to accounting by insurance companies

 Financial statements of life insurance companies
 Financial statements of non-life insurance companies

2.1 Introduction to accounting by insurance companies

Insurance companies, in Pakistan, are subject to the Insurance Ordinance, 2000 and Insurance
Rules, 2017 which requires all insurance companies to prepare the Financial Statements as
follows:

 in the case of a life insurer,-

 Statement of Financial Position

 Statement of Comprehensive Income

 Statement of Cash Flows

 Statement of Changes in equity

 in the case of a non-life insurer,

 Statement of Financial Position

 Statement of Comprehensive Income

 Statement of Cash Flows

 Statement of Changes in equity

Insurance companies must also pay regard to the requirements of the Companies Act, 2017 in so
far as they are not inconsistent with the Insurance Ordinance, 2000. Therefore, insurance
companies must prepare financial statements in accordance with IFRS just like any other type of
company.

Summary
All insurance companies operating in Pakistan must prepare their accounts in accordance with the
following:
 the Companies Act, 2017;
 the Insurance Ordinance, 2000;

 Insurance Rules, 2017; and

 IFRS as notified in the official Gazette by the Securities and Exchange Commission of
Pakistan for listed companies.

© Emile Woolf International 475 The Institute of Chartered Accountants of Pakistan

Advanced accounting and financial reporting

2.2 Financial statements of life insurance companies

Illustration:
STATEMENT OF FINANCIAL POSITION AS AT ………….
Note Current Prior
year year
Rupees in thousand
Assets
Property and equipment
Intangible assets x x
Investment property x x
Investments in subsidiaries and associates (applicable where equity
accounting is followed) x x
Investments x x
Equity securities x x
Government securities x x
Debt securities x x
Term deposits x x
Mutual funds x x
Others (please specify) x x
Loans secured against life insurance policies x x
Insurance / reinsurance receivables x x
Other loans and receivables x x
Deferred tax asset x x
Taxation - payments less provision x x
Prepayments x x
Cash & Bank x x
x x
Total Assets x x

Equity and Liabilities

Capital and reserves attributable to Company's equity holders

Ordinary share capital x x

Share premium x x

Ledger account x x

Reserves x x

Unappropriated profit/(Accumulated loss) x x

x x

Total Equity x x

Surplus on Revaluation of Fixed Assets x x

© Emile Woolf International 476 The Institute of Chartered Accountants of Pakistan

 Chapter 23: Specialised financial statements

Illustration:
Note Current Prior
year year
Rupees in thousand

Liabilities

Insurance Liabilities x x
Liabilities under Investment Contracts x x
Retirement benefit obligations x x

Deferred taxation x x

Borrowings x x

Premium received in advance x x

Insurance / reinsurance payables x x

Other creditors and accruals x x

Taxation - provision less payments x x

Total Liabilities x x
Total Equity and Liabilities x x
Contingency(ies) and commitment(s)

STATEMENT OF COMPREHENSIVE INCOME FOR THE YEAR ENDED.......

Note Current
Year Prior Year
Premium Revenue x x
Premium ceded to reinsurers x x
Net premium revenue x x

Fee income x x
Investment income x x
Net realised fair value gains on financial assets x x
Net fair value gains on financial assets
at fair value through profit or loss x x
Net rental Income x x
Net realised gains / losses on investment property x x
Net unrealised gains / losses on investment property x x
Other income / loss x x

Net income x x

© Emile Woolf International 477 The Institute of Chartered Accountants of Pakistan

Advanced accounting and financial reporting

Illustration:
Current Prior
Note Year Year

Insurance benefits x x
Recoveries from reinsurers x x
Claims related expenses x x
Net Insurance Benefits x x

Net Change in Insurance Liabilities (other than outstanding claims) x x

Acquisition expenses x x
Marketing and administration expenses x x
Other expenses x x
Total Expenses x x

Finance costs x x
Results of operating activities x x
Share of (loss)/profit of associates x x
Profit before tax x x
Income tax expense x x
Profit for the year x x
Other comprehensive income:
Change in unrealised gains/(losses) on available-for-sale financial assets x x
Currency translation differences (related to net investment in foreign
currency) x x
Actuarial gains/(losses) on retirement benefit schemes x x
Other comprehensive income for the year, net of tax x x

Total comprehensive income for the year x x

Earnings (after tax) per share – Rupees x x

Note: “The insurer may, instead of a single statement, provide two statements: a statement
displaying components of profit or loss (separate profit and loss account) and a second
statement beginning with profit or loss and displaying components of other comprehensive
income (statement of comprehensive income).”

© Emile Woolf International 478 The Institute of Chartered Accountants of Pakistan

 Chapter 23: Specialised financial statements

Illustration: 1
NOTES TO AND FORMING PART OF THE FINANCIAL STATEMENTS FOR THE YEAR ENDED
_____________
Please Note that the insurance companies are required to give disclosures according to the
Companies Act, 2017, however, only relevant notes have been reproduced in the Study Support
Material.

BASIS OF PREPARATION AND STATEMENT OF COMPLIANCE

These financial statements are prepared in accordance with approved accounting and reporting
standards as applicable in Pakistan. Approved accounting standards comprise of such International
Financial Reporting Standards (IFRS) issued by the International Accounting Standards Board as are
notified under the Companies Act, 2017, provisions of and directives issued under the Companies
Act, 2017, the Insurance Ordinance, 2000, the Insurance Rules, 2017 and the Insurance Accounting
Regulations, 2017. Where the provisions of and directives issued under the Companies Act, 2017
differ, the Insurance Ordinance, 2000, the Insurance Rules, 2017 and the Insurance Accounting
Regulations, 2017 shall prevail.
NET INSURANCE PREMIUM REVENUE
Total (Current (Total Prior
Year) Year)
Gross Premiums
Regular Premium Individual Policies* x x
First year x x
Second year renewal x x
Subsequent year renewal x x

Single Premium Individual Policies x x

Group Policies with Cash Values x x

Group Policies without Cash Values x x

Less: Experience refund (if any) x x

Annuities x x

Total Gross Premiums x x

Less: Reinsurance Premiums Ceded

On individual life First year business x x
On individual life Second year business x x
On individual life Renewal business x x
On group policies x x
Less: Experience refund (if any) x x
Less: Reinsurance commission on risk premiums x x
On annuities x x
On others (please specify) x x

Net Premiums x x

© Emile Woolf International 479 The Institute of Chartered Accountants of Pakistan

Advanced accounting and financial reporting

Illustration:
Individual policies are those underwritten on an individual basis, and include joint life policies
underwritten as such
NET INSURANCE BENEFITS
(Total Current (Total Prior
Year) Year)
Gross Claims
Claims under individual policies x x
by death x x
by insured event other than death x x
by maturity x x
by surrender x x
annuity payments x x
bonus in cash x x
Total gross individual policy claims x x
Claims under group policies x x
by death x x
by insured event other than death x x
by maturity x x
by surrender x x
annuity payments x x
bonus in cash x x
Total gross policy claims x x
Total Gross Claims x x
Less: Reinsurance Recoveries x x
On Individual life claims x x
On Group Life claims x x
On annuities x x
On others x x

Net Insurance benefit expense x x

2.3 Financial Statements of Non-Life Insurance Companies

Illustration:
STATEMENT OF FINANCIAL POSITION AS AT ………….
Note Current Prior Year
Year
Rupees in thousand
Assets
Property and equipment x x
Intangible assets x x
Investment property x x
Investments in subsidiary and associate x x
Investments

© Emile Woolf International 480 The Institute of Chartered Accountants of Pakistan

 Chapter 23: Specialised financial statements

Equity securities x x

Debt securities x x
Term deposits x x
Loans and other receivables x x
Insurance / Reinsurance receivables x x
Reinsurance recoveries against outstanding claims x x
Salvage recoveries accrued x x
Deferred Commission Expense / Acquisition cost x x
Deferred taxation x x
Taxation - payment less provisions x x
Prepayments x x
Cash & Bank x x
Total Assets x x
Equity and Liabilities x x

Capital and reserves attributable to Company's equity holders

Ordinary share capital x x
Share premium x x
Reserves x x
Unappropriated profit/(Accumulated loss) x x
x x
Total Equity x x

Surplus on revaluation of fixed assets x x

Liabilities x x
Underwriting Provisions
Outstanding claims including IBNR x x
Unearned premium reserves x x
Premium deficiency reserves x x
Unearned Reinsurance Commission x x
Retirement benefit obligations x x
Deferred taxation x x
Borrowings x x
Premium received in advance x x
Insurance / Reinsurance Payables x x
Other Creditors and Accruals x x
Taxation - provision less payment x x
Total Liabilities x x

Total Equity and Liabilities x x

Contingency(ies) and commitment(s) x x

© Emile Woolf International 481 The Institute of Chartered Accountants of Pakistan

Advanced accounting and financial reporting

Illustration:
STATEMENT OF COMPREHENSIVE INCOME FOR THE YEAR ENDED ………….
(as per one Statement approach)
Note Current Prior Year
Year
Rupees in thousand
Net insurance premium x x

Net Insurance claims x x

Premium deficiency x x
Net Commission and other acquisition costs x x
Insurance claims and acquisition expenses x x
Management Expenses x x
Underwriting results x x
Investment income x x
Rental income x x
Other income x x
Other expenses x x
Results of operating activities x x
Finance costs x x
Share of (loss)/profit of associates x x
Profit before tax x x
Income tax expense x x
Profit after tax x x
Other comprehensive income:

Unrealised gains / (losses) on available-for-sale investments x x

Others (please specify) x x
Other comprehensive income for the year x x

Total comprehensive income for the year x x

Earnings (after tax) per share - Rupees x x

Note: The company has the option to prepare the statement of comprehensive income as per one
statement approach or two statement approach.

© Emile Woolf International 482 The Institute of Chartered Accountants of Pakistan

 Chapter 23: Specialised financial statements

Illustration:
NOTES TO AND FORMING PART OF THE FINANCIAL STATEMENTS FOR THE YEAR ENDED
_____________
Please Note that the insurance companies are required to give disclosures according to the
Companies Act, 2017, however, only relevant notes have been reproduced in the Study Support
Material.
BASIS OF PREPARATION AND STATEMENT OF COMPLIANCE
These financial statements are prepared in accordance with approved accounting standards as
applicable in Pakistan. Approved accounting standards comprise of such International Financial
Reporting Standards (IFRS) issued by the International Accounting Standards Board as are notified
under the Companies Ordinance, 1984, provisions of and directives issued under the Companies
Ordinance,1984, the Insurance Ordinance, 2000, the Insurance Rules, 2017 and the Insurance
Accounting Regulations, 2017. In case requirements differ, the provisions or directives of the
Companies Ordinance, 1984, Insurance Ordinance, 2000 the Insurance Rules, 2017 and the
Insurance Accounting Regulations, 2017 shall prevail.
(Current (Prior
Year) Year)
Rupees in '000
NET INSURANCE PREMIUM
Written Gross Premium x x
Add: Unearned premium reserve opening x x
Less: Unearned premium reserve closing x x
Premium earned x x

Less :Reinsurance premium ceded x x

Add: Prepaid reinsurance premium opening x x
Less: Prepaid reinsurance premium closing x x

Reinsurance expense x x
x x
NET INSURANCE CLAIMS EXPENSE
Claim Paid x x
Add : Outstanding claims including IBNR closing x x
Less: Outstanding claims including IBNR Opening x x
Claims expense x x

Less: Reinsurance and other recoveries received x x

Add: Reinsurance and other recoveries in respect
of outstanding claims net of impairment (if any)
opening x x
Less: Reinsurance and other recoveries in respect
of outstanding claims net of impairment (if any)
closing x x
Reinsurance and other recoveries revenue x x
x x

© Emile Woolf International 483 The Institute of Chartered Accountants of Pakistan

Advanced accounting and financial reporting

Illustration:
(Current (Prior
Year) Year)
Rupees in '000
NET COMMISSION EXPENSE / ACQUISITION COST
Commission paid or payable x x
Add: Deferred commission expense opening x x
Less: Deferred commission expense closing x x
Net Commission x x
Less: Commission received or recoverable x x
Add: Unearned Reinsurance Commission x x
Less: Unearned Reinsurance Commission x x
Commission from reinsurers x x
x x
x x
Note: The students are advised to refer to the latest Financial Statements of the insurance
companies for further understanding of the formats.

© Emile Woolf International 484 The Institute of Chartered Accountants of Pakistan

 Chapter 23: Specialised financial statements

3 BANKS
Section overview

 Introduction to accounting by banks

 Statement of financial position
 Profit and Loss account
 Statement of comprehensive income
 Other statements and disclosures

3.1 Introduction to accounting by banks

Section 34 of the Banking Companies Ordinance 1962 requires that every bank incorporated in
Pakistan must prepare financial statements in accordance with the second schedule of the act.
The second schedule requirements are now published as in BPRD (Banking Policy and Regulation
Department) circular No. 2 of 2018 issued by the State Bank of Pakistan.
This also applies to banks incorporated overseas in respect of all business transacted through
branches in Pakistan.
Banks must also pay regard to the requirements of the Companies Act, 2017 in so far as they are
not inconsistent with the Banking Companies Ordinance 1962. Therefore, banks must prepare
financial statements in accordance with IFRS just like any other type of company.
Summary

All banks operating in Pakistan must prepare their accounts in accordance with the following:
 directives issued by the State Bank of Pakistan;
 the Banking Companies Ordinance 1962;
 IFRS as notified in the official Gazette by the Securities and Exchange Commission of
Pakistan for listed companies under section 234(3)(i) of the Companies Act, 2017.
This is the case whether the bank is incorporated in Pakistan or outside Pakistan and whether it
listed or no.
BPRD circular No. 2 of 2018

BPRD circular No. 2 of 2018 contains formats that must be used when preparing financial
statements. The formats for the statement of financial performance (profit and loss account) and
statement of financial position (balance sheet) are shown in the following sections.

© Emile Woolf International 485 The Institute of Chartered Accountants of Pakistan

Advanced accounting and financial reporting

3.2 Statement of financial position

Illustration:

Statement of financial position as at XX/XX/XXXX

Current Prior Year
Year
----(Rupees in ‘000)----
ASSETS -
Cash and balances with treasury banks x x
Balances with other banks x x
Lendings to financial institutions x x
Investments x x
Advances x x
Fixed assets x x
Intangible assets x x
Deferred tax assets x x
Other assets x x
x x
LIABILITIES
Bills payable x x
Borrowings x x
Deposits and other accounts x x
Liabilities against assets subject to finance lease x x
Sub-ordinated loans x x
Deferred tax liabilities x x
Other liabilities x x
x x
NET ASSETS x x

REPRESENTED BY
Share capital/ Head office capital account – net x x
Reserves x x
Surplus/ (Deficit) on revaluation of assets x x
Unappropriated/ Unremitted profit x x
x x
CONTINGENCIES AND COMMITMENTS

© Emile Woolf International 486 The Institute of Chartered Accountants of Pakistan

 Chapter 23: Specialised financial statements

3.3 Profit and Loss account

Illustration:
Profit and Loss account for the year ended _______
Note Current Prior Year
Year
----(Rupees in ‘000)------
Mark-up/return/interest earned x x
Mark-up/return/interest expensed (x) (x)
Net mark-up/ interest income

Non mark-up/interest income

Fee and Commission Income x x
Dividend Income x x
Foreign Exchange Income x x
Income / (loss) from derivatives x x
Gain / (Loss) on securities x x
Other Income x x
Total non-markup/interest Income x x
Total Income x x

NON MARK-UP/INTEREST EXPENSES

Operating expenses x x
Workers Welfare Fund x x
Other charges x x
Total non-markup/interest expenses x x

Profit / (Loss) Before Provisions x x

Provisions and write offs - net x x
Extra ordinary / unusual items (to be specified) x x
PROFIT/(LOSS) BEFORE TAXATION x x

Taxation x x

PROFIT/(LOSS) AFTER TAXATION x x

Basic Earnings/(Loss) per share x x

Diluted Earnings/(Loss) per share x x

© Emile Woolf International 487 The Institute of Chartered Accountants of Pakistan

Advanced accounting and financial reporting

3.4 STATEMENT OF COMPREHENSIVE INCOME

Illustration:
Statement of comprehensive income for the year ended _____
Current Prior Year
Year
----(Rupees in ‘000)------

Profit after taxation for the year x x

Other comprehensive income

Items that may be reclassified to profit and loss account in

subsequent periods:
Effect of translation of net investment in foreign branches x x
Movement in surplus / (deficit) on revaluation of investments -
net of tax x x
Others (to be specified) x x
x x

Items that will not be reclassified to profit and loss account in

subsequent periods:
Remeasurement gain / (loss) on defined benefit obligations - x x
net of tax
Movement in surplus on revaluation of operating fixed assets -
net of tax x x
Movement in surplus on revaluation of non-banking assets -
net of tax x x
Others (to be specified) x x
x x
Total comprehensive income x x

3.5 Other statements and disclosures

Banks are subject to disclosure requirements that require them to provide information on
accounting issues specific to banks.
 Cash and Balance with Treasury banks
 Lending to financial institutions
 Investments
 Advances
 Borrowings
 Deposits and other accounts.

© Emile Woolf International 488 The Institute of Chartered Accountants of Pakistan

 Chapter 23: Specialised financial statements

Cash and balances with treasury banks

Illustration:
Cash and balances with treasury banks
(Current (Prior
Year) Year)
Rupees in '000
In hand
 local currency x x
 foreign currencies x x
x x
With State Bank of Pakistan in
 local currency current account x x
 foreign currency current accounts x x
 local currency deposit account (to be specified) x x
 foreign currency deposit accounts x x
x x
With other central banks in
 Foreign currency current account x x
 Foreign currency deposit account x x
x x
With National Bank of Pakistan
 local currency current account x x
 local currency deposit account x x
x x
Prize bonds x x
x x

Disclose information about the extent and nature of the deposit accounts, including significant
terms and conditions that may affect the amount, timing and certainty of future cash flows.
Lending To Financial Institutions
Illustration:
Lending to financial institutions

(Current (Prior
Year) Year)
Rupees in '000
LENDINGS TO FINANCIAL INSTITUTIONS
Call / clean money lendings x x
Repurchase agreement lendings (Reverse Repo) x x
Bai Muajjal receivable x x
- with State Bank of Pakistan x x
- with other financial institutions x x
Others (to be specified) x x
x x
Less: provision held against Lending to Financial Institutions x x
Lending to Financial Institutions - net of provision x x

© Emile Woolf International 489 The Institute of Chartered Accountants of Pakistan

Advanced accounting and financial reporting

Disclose information about the extent and nature, including significant terms and conditions that
may affect the amount, timing and certainty of future cash flows.

Illustration:
Particulars of lending
(Current (Prior
Year) Year)
Rupees in '000
In local currency x x
In foreign currencies x x
x x

Current Year Prior Year

Securities held as collateral
against Lending Held Further Further
Held by
by given as Total given as Total
to financial institutions Bank
Bank collateral collateral

Rupees in '000
Market Treasury Bills x x x x x x
Pakistan Investment
Bonds x x x x x x
Others (to be specified) x x x x x x
Total x x x x x x

Current Year Prior Year

Category of classification Classified Provision Classified Provisi
Lending held Lending on held
Rupees in '000
Domestic
Other assets especially
mentioned x x x x
Substandard x x x x
Doubtful x x x x
Loss x x x x
x x x x
Overseas
Not past due but
impaired x x x x
Overdue by:
Upto 90 days x x x x
91 to 180 days x x x x
181 to 365 days x x x x
˃ 365 days x x x x
x x x x
Total x x x x

The aggregate amount of relaxation in any classification / provisioning granted by SBP should be
disclosed in a sub-note along with financial impact.

© Emile Woolf International 490 The Institute of Chartered Accountants of Pakistan

 Chapter 23: Specialised financial statements

Investments
Disclosures must show investments by type (meaning how they are classified in the financial
statements) and by segment (meaning the market segment that has been invested in.
The balances on both should agree.

Illustration:
Investments by type:
(Current Year) (Prior Year)
Cost /
Cost / Provision Surplus Provision Surplus
Carrying Amor Carrying
Amortised for / for /
Value t-ised Value
cost diminution (Deficit) diminution (Deficit)
cost
Rupees in '000
Held-for-trading securities
Federal
Government
Securities x x x x x x x x
Provincial
Government
Securities x x x x x x x x
Shares x x x x x x x x
Non-Government
Debt Securities x x x x x x x x
Foreign
Securities x x x x x x x x
Others (to be
specified) x x x x x x x x
x x x x x x x x
Available-for-sale securities
Federal
Government
Securities x x x x x x x x
Provincial
Government
Securities x x x x x x x x
Shares x x x x x x x x
Non-Government
Debt Securities x x x x x x x x
Foreign
Securities x x x x x x x x
Others (to be
specified) x x x x x x x x
x x x x x x x x

© Emile Woolf International 491 The Institute of Chartered Accountants of Pakistan

Advanced accounting and financial reporting

Illustration:

(Current Year) (Prior Year)

Cost /
Cost / Provision Surplus Provision Surplus
Carrying Amort Carrying
Amortised for / for /
Value -ised Value
cost diminution (Deficit) diminution (Deficit)
cost
Rupees in '000
Held-to-maturity securities
Federal
Government
Securities x x x x x x x x
Provincial
Government
Securities x x x x x x x x
Non-Government
Debt Securities x x x x x x x x
Foreign Securities x x x x x x x x
Others (to be
specified) x x x x x x x x
x x x x x x x x
Associates x x x x x x x x
Subsidiaries x x x x x x x x
Total Investments x x x x x x x x

For Investments in associates and subsidiaries, give details in respect of individual entities
specifying percentage of holding and country of incorporation along with details regarding assets,
liabilities, revenue, profit after taxation and total comprehensive income of these entities.

Illustration:
Investments by segments:
Federal Government Securities
(Current Year) (Prior Year)
Cost /
Cost / Provision Surplus Provision Surplus
Carrying Amor Carrying
Amortised for / for /
Value t-ised Value
cost diminution (Deficit) diminution (Deficit)
cost
Rupees in '000
Market Treasury
Bills x x x x X x x x
Pakistan
Investment Bonds x x x x X x x x
Ijarah Sukuks x x x x X x x x
Others ( All
investments to be
specified) x x x X x x x x
x x x X x x x x

© Emile Woolf International 492 The Institute of Chartered Accountants of Pakistan

 Chapter 23: Specialised financial statements

Illustration:

(Current Year) (Prior Year)

Cost /
Cost / Provision Surplus Provision Surplus
Carrying Amor Carrying
Amortised for / for /
Value t-ised Value
cost diminution (Deficit) diminution (Deficit)
cost
Rupees in '000
Provincial
Government
Securities x x x X x x x x

Shares:
Listed Companies x x x X x x x x
Unlisted
Companies x x x X x x x x
x x x X x x x x
Non-Government
Debt Securities
Listed x x x X x x x x
Unlisted x x x X x x x x
x x x X x x x x
Foreign Securities
Government
securities x x x X x x x x
Non-Government
Debt securities x x x X x x x x
Equity securities x x x X x x x x
x x x X x x x x

Associates
(disclose
individually by
name) x x x x x x x x

Subsidiaries
(disclose
individually by
name) x x x x x x x x

Total Investments x x x x x x X x

© Emile Woolf International 493 The Institute of Chartered Accountants of Pakistan

Advanced accounting and financial reporting

Illustration:
Provision for diminution in value of investments Current Prior
Year Year

Opening balance x x
Exchange adjustments x x

Charge / reversals
Charge for the year x x
Reversals for the year x x
Reversal on disposals x x
x x

Transfers - net x x
Amounts written off x x
Closing Balance x x

Advances

Illustration:

Non
Performing Total
Performing

Current Prior Current Prior Curren Prior

Year Year Year Year t Year Year

Rupees in '000

Loans, cash credits, running finances, etc. x x x x x x

Islamic financing and related

assets x x x x x x

Bills discounted and purchased x x x x x x

Advances - gross x x x x x x

Provision against advances

- Specific x x x x x x

- General x x x x x x

x x x x x x

Advances - net of provision x x x x x x

© Emile Woolf International 494 The Institute of Chartered Accountants of Pakistan

 Chapter 23: Specialised financial statements

Illustration:
Includes Net Investment in Finance Lease as disclosed below:
(Current Year) (Prior Year)
Later
Not
than Over Later than
later Not later Over
one and five one and
than Total than one five Total
less year less than
one year years
than five s five years
year
years
Rupees in '000
Lease rentals x x x x x x x
receivable x
Residual value x x x x x x x x
Minimum lease x x x x x x x x
payments
Financial charges for
future periods x x x x x x x x
x x x x x x x x
Present value of
minimum
lease payments x x x x x x x x

(Current Year) (Prior Year)

Particulars of advances
(Gross) Rupees in '000
In local currency x x
In foreign currencies x x
x x

Advances include Rs._______ (20XX ---------) which have been placed under non-performing status
as detailed below:-
Current Year Prior Year
Non Non
Performing Provision Performing Provision
Category of Classification Loans Loans
Rupees in '000
Domestic
Other Assets Especially
Mentioned x x x x
Substandard x x x x
Doubtful x x x x
Loss x x x x
x x x x
Overseas
Not past due but impaired x x x x

© Emile Woolf International 495 The Institute of Chartered Accountants of Pakistan

Advanced accounting and financial reporting

Illustration:

Current Year Prior Year

Category of Classification Non Non

Performing Performing
Loans Provision Loans Provision
Rupees in '000
Overdue by:
Upto 90 days x x x x
91 to 180 days x x x x
181 to 365 days x x x x
˃ 365 days x x x x

x x x x
Total x x x x
Particulars of provision against advances
(Current Year) (Prior Year)
Specifi General Total Specifi General Total
c c
Rupees in '000
Opening balance x x x x x x
Exchange adjustments x x x x x x
Charge for the year x x x x x x
Reversals x x x x x x
x x x x x x
Amounts written off x x x x x x
Amounts charged off - agriculture
financing x x x x x x
Other movements (to be
specified) x x x x x x
Closing balance x x x x x x
Particulars of provision against advances
(Current Year) (Prior Year)
Specifi General Total Specifi General Total
c c
Rupees in '000

In local currency x x x x x x
In foreign currencies x x x x x x
x x x x x x

The Bank should adequately disclose the details and impact of Forced Sale Value (FSV) benefit
availed as allowed under instructions issued by the State Bank of Pakistan.

© Emile Woolf International 496 The Institute of Chartered Accountants of Pakistan

 Chapter 23: Specialised financial statements

Borrowings
Illustration:
(Current
(Prior Year)
Year)
Rupees in '000
Secured
Borrowings from State Bank of Pakistan
Under export refinance scheme x x
Under Locally Manufactured Machinery (LMM) scheme x x
Others (to be specified) x x
x x
Repurchase agreement borrowings x x
Borrowings from subsidiary companies, managed modarabas
and associated undertakings x x
Borrowings from directors (including chief executive) of the bank x x
Others (to be specified) x x
Total secured x x
Unsecured
Call borrowings x x
Overdrawn nostro accounts x x
Others (to be specified) x x
Total unsecured x x
x x
Deposits and other accounts
Illustration:
Current Year Prior Year
In Local In Foreign In Local In Foreign
Total Total
Currency currencies Currency currencies
Rupees in '000
Customers
Current deposits x x x x x x
Savings deposits x x x x x x
Term deposits x x x x x x
Others x x x x x x
x x x x x x
Financial Institutions
Current deposits x x x x x x
Savings deposits x x x x x x
Term deposits x x x x x x
Others x x x x x x
x x x x x x
x x x x x x
Current accounts - deposits repayable on demand, non-remunerative
Saving accounts - deposits repayable on demand, remunerative
Others: Disclose those accounts in this category that are neither current or saving accounts and
those do not fall under the aforesaid definition of current and saving acounts e.g. margin, call
deposits etc.
Vostro accounts should be classified here.
Note: The students are advised to refer to the latest published financial statements of the
Banks in Pakistan for further understanding of the applicable formats.

© Emile Woolf International 497 The Institute of Chartered Accountants of Pakistan

Advanced accounting and financial reporting

4 MUTUAL FUNDS
Section overview

 Introduction to mutual funds

 Accounting issues
 Financial statements of mutual funds
 Other statements and disclosures

4.1 Introduction to mutual funds

The mutual funds industry is regulated by The Securities and Exchange Commission of Pakistan
(SECP).
A mutual fund is a collective investment scheme, which specialises in investing a pool of money
collected from investors for the purpose of investing in shares, bonds and other securities. This
gives small investors access to professionally managed, diversified portfolios of equities, debt
instruments etc. that they would otherwise not be able to achieve.
Mutual funds are operated by asset management companies (AMCs). An AMC is a public limited
company registered under Companies Act, 2017.
Investors purchase units (shares) and receive a share of income based on the number of units
(shares) which they own. The value of the units (shares) changes on an ongoing basis so the
holders are exposed to capital gain or loss.
The value of a unit (share) is based on the net asset value at the date of the valuation and the
number of units available.

Formula: Unit price

Current market value of all assets - liabilities

Unit price =
Total number of units outstanding

Types of mutual funds

There are basically two types of mutual funds:
 Open-ended mutual funds:
 Open-ended mutual funds (also called unit trusts) are funds which continually issue
or redeem new units on demand.
 Units may be purchased or redeemed at the prevailing net asset value.
 Trading is through a management company which announces offer and redemption
prices daily.
 Closed-ended mutual funds
 Closed-ended mutual funds have a fixed number of units which are quoted on an
exchange.
 Units are traded on the exchange based on price determined by market forces which
is closely related with the Net Asset Value per unit.

© Emile Woolf International 498 The Institute of Chartered Accountants of Pakistan

 Chapter 23: Specialised financial statements

4.2 Accounting issues

Accounting for interests in funds by the AMCs
A mutual fund is an entity controlled by the AMC that manages it. In the absence of rules to the
contrary, an AMC which managed a fund would classify it as a subsidiary and therefore have
consolidate it.
IFRS 10 contains an exemption from the general requirement to consolidated controlled entities in
this circumstance.
An investment entity must not consolidate the entities that it controls but it must measure them at
fair value through profit or loss in accordance with IFRS 9: Financial Instruments.
Nature of the units
Units in open ended mutual funds are redeemable on demand. This means that in the absence of
further guidance they would be classified as liabilities in accordance with the definition of liabilities
found in IAS 32: Financial instruments: Presentation. In that case, the statement of financial
position of such a fund would have no equity.
IAS 32 contains rules under which instruments of this kind are classified as equity. It describes
such instruments as puttable instruments and rules that they should be classified as equity as long
as they meet certain criteria. These criteria are designed to include units of mutual funds but
prevent other liabilities from being classified as equity when it would not be appropriate to do so.

4.3 Financial statements of mutual funds

Mutual funds: Statement of Comprehensive Income

Illustration:
Statement of comprehensive income for the year ended XX/XX/XXXX
INCOME Rs. m
Mark-up/ interest income X
Dividend income X
Gain/(loss) on sale of investments X
Other income X
X
EXPENSES
Remuneration to management X
Brokerage commissions and fees X
Administrative and general expenses X
Othe expenses X
(X)
NET INCOME FOR THE YEAR X
Element of income paid on redemption of unit (X)
Net Income Available for distribution X
Net Income Available for distribution:
Pertaining of Cpital Gains X
Pertaining to other than capital gains X

© Emile Woolf International 499 The Institute of Chartered Accountants of Pakistan

Advanced accounting and financial reporting

Mutual funds: Statement of financial position

Illustration: Statement of financial position format for a mutual fund

Statement of financial position as at XX/XX/XXXX

Rs. m
ASSETS
Cash and bank balances X
Investments X
Others X
TOTAL ASSETS X

LIABILITIES
Payable to investment advisor X
Others X
X
NET ASSETS X
OUTSTANIND UNITS X
NET ASSETS VALUE PER UNIT X

4.4 Other statements and disclosures

Mutual funds must provide information on distributions made in the period and explain the
movement on unit holders’ funds in the period.
Movement in unit holders’ funds

Illustration:

Statement of Movement in unit holders’ funds for the year ended XX/XX/XXXX

Undistributed
Capital value Total
Income
--------------- Rs. in million ---------------
Net assets at beginning of the year X X X
Issue of xxxx units:
Capital value X - X
Element of income X - X
Total proceeds on issuance of units X - X
Redemption of xxxx units:
Capital value (X) - (X)
Element of loss (X) (X) (X)
Total payment of redemption of units (X) (X) (X)

Total comprehensive income for the year - X X

Distribution during the year - (X) (X)
Net assets at end of the year X X X

© Emile Woolf International 500 The Institute of Chartered Accountants of Pakistan

 Chapter 23: Specialised financial statements

Undistributed
Capital value Total
Income
--------------- Rs. in million ---------------
Undistributed income brought forward
Realized income X X
Unrealized income X X
X X
Accounting income available for distribution
Relating to capital gain X X
Excluding capital gain X X
X X
Distribution during the year (X) (X)
Undistributed income carried forward X X

Undistributed income carried forward

Realized income X X
Unrealized loss (X) (X)
X X

Note: The students are advised to refer to the latest Financial Statements of the mutual
funds for further understanding of the formats.

© Emile Woolf International 501 The Institute of Chartered Accountants of Pakistan

Advanced accounting and financial reporting

5 IAS 26: RETIREMENT BENEFIT PLANS

Section overview

 Scope
 Definitions
 Valuation of plan assets
 Defined contribution plans
 Defined benefit plans
 Disclosure
 Other statements

5.1 Scope
IAS 26 complements IAS 19, Employee Benefits which is concerned with the determination of the
cost of retirement benefits in the financial statements of employers.
IAS 26 applies to the reports of retirement benefit plans whether they are:
 defined contribution plans; or
 defined benefit plans; and
 regardless of:
 whether a fund has a separate legal identity; or
 whether there are trustees.
All other IFRS apply to the reports of retirement benefit plans to the extent that they are not
superseded by IAS 26.
Insured benefits
Retirement benefit plans with assets invested with insurance companies are within the scope of
IAS 26 unless the contract with the insurance company is in the name of a specified participant or
a group of participants and the retirement benefit obligation is solely the responsibility of the
insurance company.
Outside scope
IAS 26 does not deal with other forms of employment benefits such as employment termination
indemnities, deferred compensation arrangements, long-service leave benefits, special early
retirement or redundancy plans, health and welfare plans or bonus plans.
Government social security type arrangements are also excluded from the scope of IAS 26.
5.2 Definitions

Definition
Retirement benefit plans are arrangements whereby an entity provides benefits for its employees
on or after termination of service (either in the form of an annual income or as a lump sum) when
such benefits, or the employer's contributions towards them, can be determined or estimated in
advance of retirement from the provisions of a document or from the entity's practices.

A retirement benefit plan is a reporting entity separate from the employers of the participants in the
plan.
Retirement benefit plans are known by a variety of names, for example, pension schemes,
superannuation schemes; or retirement benefit schemes'

© Emile Woolf International 502 The Institute of Chartered Accountants of Pakistan

 Chapter 23: Specialised financial statements

Definitions
Defined contribution plans are retirement benefit plans under which amounts to be paid as
retirement benefits are determined by contributions to a fund together with investment earnings
thereon.
Defined benefit plans are retirement benefit plans under which amounts to be paid as retirement
benefits are determined by reference to a formula usually based on employees' earnings and/or
years of service.
Funding is the transfer of assets to an entity (the fund) separate from the employer's entity to meet
future obligations for the payment of retirement benefits.
Participants are the members of a retirement benefit plan and others who are entitled to benefits
under the plan.
Net assets available for benefits are the assets of a plan less liabilities other than the actuarial
present value of promised retirement benefits.
Actuarial present value of promised retirement benefits is the present value of the expected
payments by a retirement benefit plan to existing and past employees, attributable to the service
already rendered.
Vested benefits are benefits, the rights to which, under the conditions of a retirement benefit plan,
are not conditional on continued employment.

5.3 Valuation of plan assets

Retirement benefit plan investments are carried at fair value.
The fair value of marketable securities is market value.
Where an estimate of fair value is not possible for plan asset the reason why this is the case must
be disclosed.
Securities that have a fixed redemption value and that have been acquired to match the obligations
of the plan may be carried at amounts based on their ultimate redemption value assuming a
constant rate of return to maturity (amortised cost).

5.4 Defined Contribution Plans

Objective of report
The reporting objective is to provide information about the plan and the performance of its
investments.
 The participants are interested in
 the activities of the plan because they directly affect the level of future benefits; and
 knowing whether contributions have been received and proper control has been
exercised to protect the rights of beneficiaries.
 An employer is interested in the efficient and fair operation of the plan.
The reporting objective is usually achieved by providing a report including:
 a description of significant activities for the period and the effect of any changes relating to
the plan, and its membership and terms and conditions;
 statements reporting on the transactions and investment performance for the period and the
financial position of the plan at the end of the period; and
 a description of the investment policies.

© Emile Woolf International 503 The Institute of Chartered Accountants of Pakistan

Advanced accounting and financial reporting

Requirement
The report of a defined contribution plan must contain:
 a statement of net assets available for benefits; and
 a description of the funding policy.

5.5 Defined Benefit Plans

Objective of report
The reporting objective is to provide information about the financial resources and activities of the
plan that is useful in assessing the relationships between the accumulation of resources and plan
benefits over time.
This is usually achieved by providing a report including the following:
 a description of significant activities for the period and the effect of any changes relating to
the plan, and its membership and terms and conditions;
 statements reporting on the transactions and investment performance for the period and the
financial position of the plan at the end of the period;
 actuarial information either as part of the statements or by way of a separate report; and
 a description of the investment policies.
Requirement
The report must contain either:
 a statement that shows:
 the net assets available for benefits;
 the actuarial present value of promised retirement benefits, distinguishing between
vested benefits and non-vested benefits; and
 the resulting excess or deficit; or
 a statement of net assets available for benefits including either:
 a note disclosing the actuarial present value of promised retirement benefits,
distinguishing between vested benefits and non-vested benefits; or
 a reference to this information in an accompanying actuarial report.
The report should explain:
 the relationship between the actuarial present value of promised retirement benefits; and the
net assets available for benefits; and
 the policy for the funding of promised benefits.
If an actuarial valuation has not been prepared at the date of the report, the most recent valuation
is used as a base and the date of the valuation disclosed.
Actuarial Present Value of Promised Retirement Benefits
The actuarial present value of promised retirement benefits is based on the benefits promised
under the terms of the plan on service rendered to date using either:
 current salary levels; or
 projected salary levels

© Emile Woolf International 504 The Institute of Chartered Accountants of Pakistan

 Chapter 23: Specialised financial statements

5.6 Disclosure
Specific requirement
The report of a retirement benefit plan (defined benefit or defined contribution) must contain the
following information:
 a statement of changes in net assets available for benefits;
 a summary of significant accounting policies; and
 a description of the plan and the effect of any changes in the plan during the period.
Guidance
Reports provided by retirement benefit plans include the following, if applicable:
 a statement of net assets available for benefits disclosing:
 assets at the end of the period suitably classified;
 the basis of valuation of assets;
 details of any single investment exceeding either 5% of the net assets available for
benefits or 5% of any class or type of security;
 details of any investment in the employer; and
 liabilities other than the actuarial present value of promised retirement benefits;
 a statement of changes in net assets available for benefits showing the following:
 employer contributions;
 employee contributions;
 investment income such as interest and dividends;
 other income;
 benefits paid or payable (for example, as retirement, death and disability benefits, and
lump sum payments);
 administrative expenses;
 other expenses;
 taxes on income;
 profits and losses on disposal of investments and changes in value of investments; and
 transfers from and to other plans;
 a description of the funding policy;
For defined benefit plans:
 the actuarial present value of promised retirement benefits (which may distinguish between
vested benefits and non-vested benefits) based on the benefits promised under the terms
of the plan on service rendered to date using either:
 current salary levels; or
 projected salary levels;
 a description of the significant actuarial assumptions made and the method used to calculate
the actuarial present value of promised retirement benefits.

© Emile Woolf International 505 The Institute of Chartered Accountants of Pakistan

Advanced accounting and financial reporting

Report of retirement benefit plans

A description of the plan must be provided either as part of the financial information or in a separate
report.
It may contain the following:
 the names of the employers and the employee groups covered;
 the number of participants receiving benefits and the number of other participants, classified
as appropriate;
 the type of plan - defined contribution or defined benefit;
 a note as to whether participants contribute to the plan;
 a description of the retirement benefits promised to participants;
 a description of any plan termination terms; and
 changes in any of the above during the period covered by the report.
5.7 Other statements
Net assets available for benefits

Illustration:

Statement of net assets available for benefits as at XX/XX/XXXX

Assets Rs. m
Investments x
Receivable from employer x
Balances with banks x
Total assets available for benefits x

Liabilities
Payable to outgoing members (x)
Accrued expenses (x)
(x)
x
Net assets
Represented by:
Members’ fund x
Surplus on re-measurement of investments available for sale x
x

© Emile Woolf International 506 The Institute of Chartered Accountants of Pakistan

 Chapter 23: Specialised financial statements

Changes in net assets

Illustration:

Statement of changes in net assets available for benefits for the year XX/XX/XXX
Rs. m
General Reserve Fund
Balance as on xxxxx X
Contribution during the year X
Gratuity paid/payable to outgoing members (X)
X
Income:
Profit from defense saving certificates X
Dividend on investments X
Reversal of previous years impairment X
X
Expenditure
Audit fee (X)
Bank charges (X)
(X)

Balance as on xxxx X

Note: The students are advised to refer to the latest Financial Statements of any listed
company for further understanding of applicable formats.

© Emile Woolf International 507 The Institute of Chartered Accountants of Pakistan

Advanced accounting and financial reporting

© Emile Woolf International 508 The Institute of Chartered Accountants of Pakistan

 Certified Finance and Accounting Professional

24

CHAPTER
Advanced accounting and financial reporting

International public sector

accounting standards (IPSAS)

Contents
1 Overview of international public sector accounting
standards
2 The conceptual framework for general purpose financial
reporting by public sector entities
3 IPSAS 1: Presentation of financial statements
4 Financial reporting under the cash basis of accounting

© Emile Woolf International 509 The Institute of Chartered Accountants of Pakistan

Advanced accounting and financial reporting

1 OVERVIEW OF INTERNATIONAL PUBLIC SECTOR ACCOUNTING STANDARDS

Section overview

 International Federation of Accountants (IFAC)

 International Public Sector Accounting Standards Board (IPSASB)
 Scope of IPSAS
 Authority of IPSAS

1.1 International Federation of Accountants (IFAC)

IFAC is the global organisation for the accountancy profession. It is dedicated to serving the public
interest by strengthening the profession and contributing to the development of strong international
economies.
IFAC is comprised of over 175 members and associates in 130 countries and jurisdictions,
representing approximately 2.84 million accountants in public practice, education, government
service, industry, and commerce.
As part of its public interest mandate, IFAC contributes to the development, adoption, and
implementation of high-quality international public sector accounting standards through its support
of the International Public Sector Accounting Standards Board (IPSASB).

1.2 International Public Sector Accounting Standards Board (IPSASB)

The IPSASB’s objective is to serve the public interest by developing high quality accounting
standards and other publications for use by public sector entities around the world in the
preparation of general purpose financial reports with the aim of enhancing the quality, consistency,
and transparency of public sector financial reporting worldwide.

Definitions
Public sector: National governments, regional (e.g., state, provincial, territorial) governments, local
(e.g., city, town) governments and related governmental entities (e.g., agencies, boards,
commissions and enterprises).
General purpose financial reports: Financial reports intended to meet the information needs of
users who are unable to require the preparation of financial reports tailored to meet their specific
information needs

In fulfilling its objective, the IPSASB develops and issues the following publications:
 International Public Sector Accounting Standards (IPSAS) as the standards to be applied in
the preparation of general purpose financial reports of public sector entities other than
government business enterprises (see below).
 Recommended Practice Guidelines (RPGs) to provide guidance on good practice that public
sector entities are encouraged to follow.
 Studies to provide advice on financial reporting issues in the public sector. They are based
on study of the good practices and most effective methods for dealing with the issues being
addressed.
 Other papers and research reports to provide information that contributes to the body of
knowledge about public sector financial reporting issues and developments. They are aimed
at providing new information or fresh insights and generally result from research activities
such as: literature searches, questionnaire surveys, interviews, experiments, case studies
and analysis.

© Emile Woolf International 510 The Institute of Chartered Accountants of Pakistan

 Chapter 24: International public sector accounting standards (IPSAS)

Due process
The IPSASB issues exposure drafts of all proposed IPSAS and RPGs for public comment. In some
cases, the IPSASB may also issue a Consultation Paper prior to the development of an exposure
draft.
This provides an opportunity for those affected by IPSASB pronouncements to provide input and
present their views before the pronouncements are finalised and approved.
In developing its pronouncements, the IPSASB seeks input from its consultative group and
considers and makes use of pronouncements issued by:
 The International Accounting Standards Board (IASB) to the extent they are applicable to
the public sector;
 National standard setters, regulatory authorities and other authoritative bodies;
 Professional accounting bodies; and
 Other organisations interested in financial reporting in the public sector.
The IPSASB works to ensure that its pronouncements are consistent with those of IASB to the
extent those pronouncements are applicable and appropriate to the public sector.

1.3 Scope of IPSAS

As stated above IPSAS set out requirements dealing with transactions and other events in general
purpose financial reports.
The IPSAS are designed to apply to the general purpose financial reports of all public sector entities
other than government business enterprises GBEs.

Definition
Government business enterprise: An entity that has all the following characteristics:
a) is an entity with the power to contract in its own name;
b) has been assigned the financial and operational authority to carry on a business;
c) sells goods and services, in the normal course of its business, to other entities at a profit or
full cost recovery;
d) is not reliant on continuing government funding to be a going concern (other than purchases
of outputs at arm’s length); and
e) is controlled by a public sector entity.

GBEs exist for a profit motive so should apply IFRS rather than IPSAS.
The IPSASB issues IPSAS dealing with financial reporting under the cash basis of accounting and
the accrual basis of accounting. The IPSASB has also issued a comprehensive Cash Basis IPSAS
that includes mandatory and encouraged disclosures sections. This is covered in a later section.
Accruals based IPSAS
The IPSASB has published many accrual based IPSAS that are based very closely on the
equivalent IFRS. The IPSASB attempts, wherever possible, to maintain the accounting treatment
and original text of the IFRSs unless there is a significant public sector issue which warrants a
departure.
The IPSASB has also published accrual based IPSAS that deal with public sector financial
reporting issues that are not addressed by IFRS.

© Emile Woolf International 511 The Institute of Chartered Accountants of Pakistan

Advanced accounting and financial reporting

The following table lists the accruals based IPSAS.

IFRS
IPSAS
equivalent
IPSAS 1: Presentation of financial statements IAS 1

IPSAS 2: Cash flow statements IAS 7 (revised)

IPSAS 3: Accounting policies, changes in accounting estimates and errors IAS 8

IPSAS 4: The effects of changes in foreign exchange IAS 21

IPSAS 5: Borrowing costs IAS 23

IPSAS 6: Consolidated and separate financial statements IAS 27

IPSAS 7: Investments in associates IAS 28

IPSAS 8: Interests in joint ventures IAS 31 (now

superseded)
IPSAS 9: Revenue from exchange transactions IAS 18

IPSAS 10: Financial reporting in hyperinflationary economies IAS 29

IPSAS 11: Construction contracts IAS 11

IPSAS 12: Inventories IAS 2

IPSAS 13: Leases IFRS 16

IPSAS 14: Events after the reporting date IAS 10

IPSAS 15: Financial instruments: disclosure and presentation IAS 32

IPSAS 16: Investment property IAS 40

IPSAS 17: Property, plant, and equipment IAS 16

IPSAS 18: Segment reporting IFRS 8

IPSAS 19: Provisions, contingent liabilities and contingent assets IAS 37

IPSAS 20: Related party disclosures IAS 24

IPSAS 21: Impairment of non-cash-generating assets None

IPSAS 22: Disclosure of information about the general government sector None
IPSAS 23: Revenue from non-exchange transactions (taxes and transfers) None

IPSAS 24: Presentation of budget information in financial statements None

IPSAS 25: Employee benefits IAS 19

IPSAS 26: Impairment of cash-generating assets IAS 36

IPSAS 27: Agriculture IAS 41

IPSAS 28: Financial instruments: presentation IAS 32

IPSAS 29: Financial instruments: recognition and measurement IFRS 9

IPSAS 30: Financial instruments: disclosures IFRS 7

IPSAS 31: Intangible assets IAS 38

IPSAS 32: Service concession arrangements SIC 12

© Emile Woolf International 512 The Institute of Chartered Accountants of Pakistan

 Chapter 24: International public sector accounting standards (IPSAS)

IFRS
IPSAS
equivalent

IPSAS 33: First time adoption of accruals basis None

IPSAS 34: Separate financial statements IAS 27 (revised)

IPSAS 35: Consolidated financial statements IFRS 10

IPSAS 36: Investments in associates and joint ventures IAS 28 (revised)

IPSAS 37: Joint arrangements IFRS 11

IPSAS 38: Disclosure of interests in other entities IFRS 12

Financial statements should be described as complying with IPSAS only if they comply with all the
requirements of each applicable IPSAS.

1.4 Authority of IPSAS

The IPSASB does not have the power to require compliance with IPSAS. However, the IPSASB
strongly encourages governments and national standard-setters to adopt IPSAS in order to both
the quality and comparability of financial information reported by public sector entities around the
world.
IPSAS has been adopted in many jurisdictions. In Pakistan, the federal government, all provincial
governments, and district governments present their annual financial statements on the cash-basis
IPSAS.
IPSAS has also been adopted and by many supranational organisations including:
 ASEAN (Association of South-East Asian Nations);
 Commonwealth Secretariat;
 Council of Europe;
 EC (European Commission);
 Organisation for Economic Cooperation and Development (the first body in the world to
produce financial statements compliant with IPSAS in 2000).

© Emile Woolf International 513 The Institute of Chartered Accountants of Pakistan

Advanced accounting and financial reporting

2 THE CONCEPTUAL FRAMEWORK FOR GENERAL PURPOSE FINANCIAL

REPORTING BY PUBLIC SECTOR ENTITIES

Section overview

 Introduction
 Chapter 1 – The role and authority of the conceptual framework
 Chapter 2 – Objectives and users of general purpose financial reporting
 Chapter 3 – Qualitative characteristics of financial information
 Chapter 4 – Reporting entity
 Chapter 5 – Elements in financial statements
 Chapter 6 – Recognition of the elements of financial statements
 Chapter 7 – Measurement of assets and liabilities in financial statements
 Chapter 8 – Presentation in general purpose financial statements

2.1 Introduction
A conceptual framework is a system of concepts and principles that underpin the preparation of
financial statements. These concepts and principles should be consistent with one another.
The IPSASB have published a conceptual framework called “The conceptual framework for general
purpose financial reporting (GPFRs) by public sector entities”.
This deals with concepts that apply to general purpose financial reporting (financial reporting)
under the accrual basis of accounting.
This is made up of the following chapters:
 Chapter 1 – The role and authority of the conceptual framework.
 Chapter 2 – Objectives and users of general purpose financial reporting.
 Chapter 3 – Qualitative characteristics of financial information.
 Chapter 4 – Reporting entity.
 Chapter 5 – Elements in financial statements.
 Chapter 6 – Recognition of the elements of financial statements.
 Chapter 7 – Measurement of assets and liabilities in financial statements.
 Chapter 8 – Presentation in general purpose financial statements

2.2 Chapter 1 – The role and authority of the conceptual framework

The Conceptual Framework establishes the concepts that underpin general purpose financial
reporting (financial reporting) by public sector entities using the accrual basis of accounting when
preparing and presenting general purpose financial reports.
The Conceptual Framework does not contain authoritative requirements that must be followed nor
does it override the requirements of IPSAS or RPGs.
However, it might be useful in providing guidance on accounting for issues not dealt with by IPSAS
or RPGs. In these circumstances,

2.3 Chapter 2 – Objectives and users of general purpose financial reporting

The objective
Financial reporting is not an end in itself.
The objectives of financial reporting by public sector entities are to provide information about the
entity that is useful to users of GPFRs (General Purpose Financial Reporting) for accountability
purposes and for decision-making purposes.

© Emile Woolf International 514 The Institute of Chartered Accountants of Pakistan

 Chapter 24: International public sector accounting standards (IPSAS)

Users
Governments and other public sector entities raise resources from taxpayers, donors, lenders and
other resource providers for use in the provision of services to citizens and other service recipients.
These entities are accountable for their management and use of resources to those that provide
them with resources, and to those that depend on them to use those resources to deliver necessary
services.
Therefore, GPFRs of public sector entities are developed primarily to respond to the information
needs of service recipients and resource providers who do not possess the authority to require
tailored information.
Taxpayers do not provide funds on a voluntary basis so it might seem that they have little influence
and therefore no need for information but the information provided about the use of the resources
can inform voting decisions.
Information is needed to allow the assessments of such matters as:
 the performance of the entity during the reporting period in, for example:
 meeting its service delivery and other operating and financial objectives;
 managing the resources it is responsible for; and
 complying with relevant budgetary, legislative, and other authority regulating the
raising and use of resources;
 the entity’s liquidity; and
 the sustainability of the entity’s service delivery.

Information provided by general purpose financial reports might include

 financial position, financial performance and cash flows:
 budget information and compliance with legislation or other authority governing the raising
and use of resources; and
 service delivery achievements.

2.4 Chapter 3 – Qualitative characteristics of financial information

GPFRs present financial and non-financial information about economic and other phenomena.
The qualitative characteristics of information are the attributes that make that information useful for
accountability and decision-making purposes.
The qualitative characteristics of information included in GPFRs of public sector entities are:
 relevance;
 faithful representation;
 understandability;
 timeliness;
 comparability; and
 verifiability.
Pervasive constraints on information provided are materiality, cost vs benefit, and achieving an
appropriate balance between the qualitative characteristics.

2.5 Chapter 4 – Reporting entity

A public sector reporting entity is a government or other public sector organisation, program or
identifiable area of activity that prepares GPFRs.

© Emile Woolf International 515 The Institute of Chartered Accountants of Pakistan

Advanced accounting and financial reporting

Key characteristics of a reporting entity are that:

 it raises resources from (or for) constituents and/or uses resources to undertake activities
for the benefit of those constituents; and
 there are service recipients or resource providers dependent on GPFRs of the entity for
information for accountability or decision-making purposes.

2.6 Chapter 5 – Elements in financial statements

Financial statements portray the financial effects of transactions and other events by grouping them
into broad classes which share common economic characteristics. These broad classes are
termed the elements of financial statements.

Element Definition

An asset A resource presently controlled by the entity as a result of a past event.

A liability A present obligation of the entity for an outflow of resources that results from a
past event.

Revenue Increases in the net financial position of the entity, other than increases arising
from ownership contributions.

Expense Decreases in the net financial position of the entity, other than decreases
arising from ownership distributions.

Ownership Inflows of resources to an entity, contributed by external parties in their

contributions capacity as owners, which establish or increase an interest in the net financial
position of the entity.

Ownership Outflows of resources from the entity, distributed to external parties in their
distributions capacity as owners, which return or reduce an interest in the net financial
position of the entity.

2.7 Chapter 6 – Recognition of the elements of financial statements

The recognition criteria for an item are that:
 it satisfies the definition of an element; and
 it can be measured in a way that achieves the qualitative characteristics taking account of
constraints on information.

2.8 Chapter 7 – Measurement of assets and liabilities in financial statements

Measurement bases should be chosen to fairly reflect the cost of services, operational capacity
and financial capacity of the entity in a manner that is useful in holding the entity to account, and
for decision-making purposes.
The measurement basis chosen should enable users to assess:
 the cost of services provided in the period in historical or current terms;
 operational capacity (the capacity of the entity to support the provision of services in future
periods through physical and other resources); and
 financial capacity (the capacity of the entity to fund its activities).

© Emile Woolf International 516 The Institute of Chartered Accountants of Pakistan

 Chapter 24: International public sector accounting standards (IPSAS)

It is not possible to identify a single measurement basis that meets the above requirements:
Any of the following bases might be used depending on circumstance:
 historical cost;
 market value;
 replacement cost;
 net selling price; and
 value in use.

2.9 Chapter 8 – Presentation in general purpose financial statements

Presentation involves the selection, location and organisation of information that is reported in the
GPFRs.
Presentation aims to provide information that contributes towards the objectives of financial
reporting and achieves the qualitative characteristics while taking into account the constraints on
information included in GPFRs.

© Emile Woolf International 517 The Institute of Chartered Accountants of Pakistan

Advanced accounting and financial reporting

3 IPSAS 1: PRESENTATION OF FINANCIAL STATEMENTS

Section overview

 General requirements
 Structure and content

3.1 General requirements

IPSAS 1 is based very closely on IAS 1 with many paragraphs being identical apart from changes
to reflect public sector terminology and changes to references from IFRS to IPSAS.
Objective
The objective of IPSAS 1 is to prescribe the basis for presentation of general purpose financial
statements, to ensure comparability both with the entity's financial statements of previous periods
and with the financial statements of other entities
Scope
IPSAS 1 must be applied to all general purpose financial statements prepared and presented under
the accrual basis of accounting in accordance with IPSAS.
Components
A complete set of financial statements comprises:
 statement of financial position;
 statement of financial performance;
 statement of changes in net assets/equity;
 cash flow statement (IPSAS 2 – not in this syllabus);
 a comparison of budget and accrual amounts when the entity makes its approved budget
publicly available; and
 notes, comprising a summary of significant accounting policies and other explanatory notes.
Comparative information must be disclosed for all amounts unless IPSAS permits or requires
otherwise.
Overall consideration
The standard describes the following overall considerations when presenting financial statements:
 fair presentation and compliance with IPSAS;
 going concern;
 consistency of presentation;
 materiality and aggregation; and
 offset.
Fair presentation and compliance with IPSAS;
Fair presentation requires the faithful representation of the effects of transactions, other events,
and conditions in accordance with the definitions and recognition criteria set out in IPSAS.
The application of IPSAS, with additional disclosures when necessary, is presumed to result in fair
presentation.
An entity whose financial statements comply with all the requirements of IPSAS must make an
explicit and unreserved statement of such compliance in the notes.
Financial statements must generally be prepared annually. Disclosure is required if the date of the
year-end changes, and financial statements are presented for a period other than one year.

© Emile Woolf International 518 The Institute of Chartered Accountants of Pakistan

 Chapter 24: International public sector accounting standards (IPSAS)

3.2 Structure and content

Statement of financial position (balance sheet)
IPSAS 1 requires an entity to present current and non-current assets, and current and
non-current liabilities, as separate classifications on the face of its statement of financial position
unless a liquidity presentation provides more relevant and reliable information. In such cases, all
assets and liabilities must be presented broadly in order of liquidity.
Some items may be presented using a current/non-current distinction and others in order of liquidity
if this provides information that is more relevant and reliable.
Whichever method of presentation is adopted an entity must disclose the amount expected to be
recovered or settled after more than twelve months for each asset and liability line item that
combines current and non-current amounts.
IPSAS 1 provides a list of items that, as a minimum, must be shown on the face of the statement
of financial position as a ‘line item’ (in other words, on a separate line in the statement):
Additional line items should be included in the statement of financial position when presenting them
separately and is ‘relevant to an understanding of the entity’s financial position.
Statement of financial performance (income statement)
All items of revenue and expense recognised in a period must be included in surplus or deficit
unless IPSAS requires otherwise.
The minimum line items that should be included on the face of the statement of financial
performance are:
 revenue;
 finance costs;
 share of the surplus or deficit of associates and joint ventures accounted for using the equity
method;
 pre-tax gain or loss recognised on the disposal of assets or settlement of liabilities
attributable to discontinued operations;
 surplus or deficit for the period;
Additional line items may be needed to achieve fair presentation of an entity's financial
performance.
The surplus or deficit attributable to minority interests (non-controlling interests) and that
attributable to the owners of the controlling entity must also be disclosed in the statement of
financial performance as allocations for the period.
When items of revenue and expense are material, their nature and amount must be disclosed
separately
Expenses should be analysed either by nature or by function.
Statement of changes in net assets (equity)
A statement of changes in net assets/equity must be presented showing:
 Surplus or deficit for the period;
 Each item of revenue and expense for the period that is recognised directly in net
assets/equity, and the total of these items;
 The total revenue and expense for the period (calculated as the sum of the above);
 For each component of net assets/equity the effects of changes in accounting policies and
corrections of errors.

© Emile Woolf International 519 The Institute of Chartered Accountants of Pakistan

Advanced accounting and financial reporting

The following must be disclosed either on the face of the statement of changes in net assets/equity
or in the notes:
 amounts of transactions with owners acting in their capacity as owners, showing separately
distributions to owners;
 the balance of accumulated surpluses or deficits at the beginning of the period and at the
reporting date, and the changes during the period; and
 reconciliations of the carrying amount of each component of net assets/equity from
the beginning to the end of the period.
Notes
The requirements are very similar to those set out in IAS 1 and are not repeated here.

© Emile Woolf International 520 The Institute of Chartered Accountants of Pakistan

 Chapter 24: International public sector accounting standards (IPSAS)

4 FINANCIAL REPORTING UNDER THE CASH BASIS OF ACCOUNTING

Section overview

 Introduction
 Financial statements
 Accounting policies and explanatory notes
 Budget comparison

4.1 Introduction
The cash basis of accounting recognises transactions and events only when cash (including cash
equivalents) is received or paid by the entity.
Objective
This standard prescribes the manner in which general purpose financial statements should be
presented under the cash basis of accounting.
The standard is comprised of two parts:
 Part 1 is mandatory and sets out the requirements which are applicable to all entities
preparing general purpose financial statements under the cash basis of accounting.
 Part 2 is not mandatory but identifies additional accounting policies and disclosures that an
entity is encouraged to adopt to enhance its financial accountability and the transparency of
its financial statements.
Scope
An entity which prepares and presents financial statements under the cash basis of accounting
should apply the requirements of part 1 of the standard. Compliance with part 1 of the standard
should be disclosed.
The rules apply both to financial statements of an individual entity and to consolidated financial
statements.
The standard does not apply to government business enterprises.

4.2 Financial statements

Financial statements under the cash basis consist of the following components:
 statement of cash receipts and payments;
 accounting policies and explanatory notes; and
 comparison of original budget, revised budget, and actual amounts on a comparable basis
(only when the entity makes publicly available its approved budget).
Information to be presented in the statement of cash receipts and payments
The statement of cash receipts and payments should present the following amounts for the
reporting period:
 total cash receipts showing separately a sub-classification of total cash receipts using a
classification basis appropriate to the entity’s operations;
 total cash payments showing separately a sub-classification of total cash payments using a
classification basis appropriate to the entity’s operations; and
 opening and closing cash balances.

© Emile Woolf International 521 The Institute of Chartered Accountants of Pakistan

Advanced accounting and financial reporting

Total cash receipts and total cash payments should be reported on a gross basis. However, they
may be reported on a net basis when:
 they arise from transactions administered on behalf of other parties; or
 they are for items in which the turnover is quick, the amounts are large, and the maturities
are short.
Payments made by a third party on behalf of the entity should be disclosed in separate columns
on the face of the statement of cash receipts and payments:

4.3 Accounting policies and explanatory notes

Financial statements prepared under the cash basis provide readers with information about the
sources of cash raised during the period, the purposes for which cash was used and the cash
balances at the reporting date.
The measurement focus in the financial statements is balances of cash and changes therein. Notes
to the financial statements may provide additional information about liabilities, such as payables
and borrowings, and some non-cash assets, such as receivables, investments and property, plant
and equipment.
The notes to the financial statements of an entity should:
 present information about the basis of preparation of the financial statements and the
specific accounting policies selected and applied for significant transactions and other
events; and
 provide additional information which is not presented on the face of the financial statements
but is necessary for a fair presentation of the entity’s cash receipts, cash payments and cash
balances.
Notes to the financial statements should be presented in a systematic manner. Each item on the
face of the statement of cash receipts and payments and other financial statements should be
cross referenced to any related information in the notes.
General disclosures
Financial statements must generally be prepared annually. Disclosure is required if the date of the
year-end changes, and financial statements are presented for a period other than one year.
An entity should disclose the date when the financial statements were authorised for issue and
who gave that authorisation.
Comparative information should be disclosed for all numerical information required.
The presentation and classification of items in the financial statements should be retained from
one period to the next.
An entity should disclose information on any restrictions on the use of cash balances and undrawn
borrowing facilities.
An entity should disclose the following:
 the domicile and legal form of the entity, and the jurisdiction within which it operates;
 a description of the nature of the entity’s operations and principal activities;
 a reference to the relevant legislation governing the entity’s operations, if any; and
 the name of the controlling entity and the ultimate controlling entity of the economic entity
(where applicable, if any).
The financial statements should be clearly identified and distinguished from other information in
the same published document.

© Emile Woolf International 522 The Institute of Chartered Accountants of Pakistan

 Chapter 24: International public sector accounting standards (IPSAS)

Foreign currency
Cash receipts and payments arising from transactions in a foreign currency should be recorded
using the exchange rate at the date of the receipts and payments.
Cash balances held in a foreign currency should be reported using the closing rate.

4.4 Budget comparison

If an entity makes its approved budget publicly available it must present a comparison of the budget
amounts for which it is held publicly accountable and actual amounts.
This could be presented either as a separate additional financial statement or using additional
budget columns in the statement of cash receipts and payments.

© Emile Woolf International 523 The Institute of Chartered Accountants of Pakistan

Advanced accounting and financial reporting

© Emile Woolf International 524 The Institute of Chartered Accountants of Pakistan

 Certified Finance and Accounting Professional

25

CHAPTER
Advanced accounting and financial reporting

Accounting for hyperinflation

Contents
1 IAS 29: Financial reporting in hyperinflationary economies
2 Restatement of historical cost financial statements
3 Restatement of current cost financial statements
4 Other issues
5 IFRIC 7: Applying the restatement approach under IAS 29

© Emile Woolf International 525 The Institute of Chartered Accountants of Pakistan

Advanced accounting and financial reporting

1 IAS 29: FINANCIAL REPORTING IN HYPERINFLATIONARY ECONOMIES

Section overview

 Introduction
 Scope
 Requirements

1.1 Introduction
Primary financial statements are normally prepared on the historical cost basis without taking into
account:
 changes in the general level of prices or
 changes in specific prices of assets held (except to the extent that property, plant and
equipment and investments may be revalued).
Some entities may present primary financial statements prepared on a current cost basis. Current
cost accounts reflect the effects of specific price changes on the financial statements of the entity.
They do not reflect the general rate of inflation.
The accounting problem
In a hyperinflationary economy, money loses purchasing power at such a rate that comparison of
amounts from transactions occurring at different times (even within the same accounting period) is
misleading.
Reporting operating results and financial position in a hyperinflationary economy is not useful
without restatement.
What is hyperinflation?
IAS 29 does not establish an absolute rate at which hyperinflation is deemed to arise.
Features of a hyperinflationary economy include (but are not limited to) the following:
 the general population prefers to keep its wealth in non-monetary assets or in a relatively
stable foreign currency. Amounts of local currency held are immediately invested to maintain
purchasing power;
 the general population regards monetary amounts not in terms of the local currency but in
terms of a relatively stable foreign currency. Prices may be quoted in that currency;
 sales and purchases on credit take place at prices that compensate for the expected loss of
purchasing power during the credit period, even if the period is short;
 interest rates, wages and prices are linked to a price index; and
 the cumulative inflation rate over three years is approaching, or exceeds, 100%.
It is a matter of judgement when restatement of financial statements in accordance with this
standard becomes necessary.

1.2 Scope
IAS 29 must be applied to the primary financial statements (including the consolidated financial
statements) of any entity whose functional currency is the currency of a hyperinflationary economy.
IAS 29 applies from the beginning of the reporting period in which an entity identifies the existence
of hyperinflation in the country in whose currency it reports.

1.3 Requirements
The financial statements of an entity that reports in the currency of a hyper-inflationary economy
must be stated in terms of the measuring unit current at the end of reporting period date.

© Emile Woolf International 526 The Institute of Chartered Accountants of Pakistan

 Chapter 25: Accounting for hyperinflation

This applies to both:

 historical cost accounts; and,
 current cost accounts.
Comparatives should be restated in terms of the measuring unit current at the end of reporting
period date.
The gain or loss on the net monetary position should be included in net income and separately
disclosed.
It is not permitted to present the required information as a supplement to financial statements that
have not been restated. Also, separate presentation of the financial statements before restatement
is discouraged.

© Emile Woolf International 527 The Institute of Chartered Accountants of Pakistan

Advanced accounting and financial reporting

2 RESTATEMENT OF HISTORICAL COST FINANCIAL STATEMENTS

Section overview

 Statement of financial position

 Non-monetary items
 Equity balances
 Statement of profit or loss
 Gain or loss on net monetary position

2.1 Statement of financial position

All balances must be stated in terms of the measuring unit current by applying general price index
at the end of reporting period date.
Not restated
Monetary items – No restatement is necessary as monetary items are already expressed in terms
of the monetary unit current at the end of reporting period date.
Index linked assets and liabilities – The carrying value of these items will already have been
adjusted for inflation. Such items are carried at the adjusted amount in the restated statement of
financial position.
All other assets and liabilities are non-monetary.

2.2 Non-monetary items

Some non-monetary items will already be carried at the amount current at the end of reporting
period date (e.g. net realisable value or market value). These are not restated.
All other non-monetary assets and liabilities are restated. There is a different treatment for items
carried at cost and those not carried at cost.
Non-monetary items carried at cost (or cost less depreciation)
The restated cost (or cost less depreciation) is determined by applying the change in a general
price index from the date of acquisition to the end of reporting period date. Both the cost and the
accumulated depreciation will be restated. Thus the following are restated from the date of
purchase:
 property, plant and equipment;
 investments;
 inventories of raw materials and merchandise;
 goodwill; and
 patents, trademarks and similar assets.
Inventories of partly-finished and finished goods are restated from the dates on which the costs of
purchase and of conversion were incurred.
Non-monetary items carried at amounts other than cost
Revalued items will be indexed from the date of revaluation. No asset must be valued in excess of
its recoverable amount.
Equity accounted investments
Sometimes an entity may hold an investment in another entity that is accounted for under the equity
method and whose functional currency is that of a hyperinflationary economy.
In these cases the statement of financial position and statement of profit or loss of the investee
must be restated in accordance with this standard before applying the equity method.

© Emile Woolf International 528 The Institute of Chartered Accountants of Pakistan

 Chapter 25: Accounting for hyperinflation

Where the restated financial statements of the investee are expressed in a foreign currency they
are translated at closing rates.

2.3 Equity balances

At the beginning of the first period of application of this standard:
 The components of owners' equity (except retained earnings and any revaluation surplus)
are restated by applying a general price index from the dates the components were
contributed/arose.
 Any revaluation surplus that arose in previous periods is eliminated.
 Restated retained earnings are derived from all the other amounts in the restated statement
of financial position.
At the end of the first period and in subsequent periods, all components of owners' equity are
restated by applying a general price index from the beginning of the period (or the date of
contribution, if later).
Practical problems
If detailed records of the date and cost of acquisition of property, plant and equipment are not
available, then an independent professional assessment can be made of the items value in the first
period of restatement.
If a general price index is not available for the whole period (or periods) required then an estimated
index can be used. This could be based on, say, movements in the exchange rate between the
local currency and a relatively stable foreign currency.

2.4 Statement of profit or loss

The statement of profit or loss must be expressed in terms of the measuring unit current at the
reporting date.
All items in the statement of profit or loss will be restated by applying the change in the general
price index from the dates when the items of income and expenses occurred and the reporting
date.
2.5 Gain or loss on net monetary position
During a period of inflation an entity will:
 suffer a loss if it holds net monetary assets during a period of inflation because the
purchasing power of those assets will be eroded.
 make a gain if it holds net monetary liabilities because the burden of the liabilities is reduced
by inflation.
This gain or loss on the net monetary position may be derived as the difference resulting from the
restatement of non-monetary assets, owners' equity and statement of profit or loss items and the
adjustment of index linked assets and liabilities.
The gain or loss may be estimated by applying the change in a general price index to the weighted
average for the period of the difference between monetary assets and monetary liabilities.

© Emile Woolf International 529 The Institute of Chartered Accountants of Pakistan

Advanced accounting and financial reporting

3 RESTATEMENT OF CURRENT COST FINANCIAL STATEMENTS

Section overview

 Statement of financial position

 Statement of profit or loss
 Gain or loss on net monetary position

3.1 Statement of financial position

Items stated at current cost are not restated because they are already expressed in terms of the
measuring unit current at the end of reporting date.
Other items in the statement of financial position are restated.

3.2 Statement of profit or loss

The current cost statement of profit or loss, before restatement, generally reports costs current at
the time at which the underlying transactions or events occurred.
Cost of sales and depreciation are recorded at current costs at the time of consumption;
Sales and other expenses are recorded at their money amounts when they occurred.
All amounts need to be restated into the measuring unit current at the end of reporting period date
by applying a general price index.

3.3 Gain or loss on net monetary position

The gain or loss on the net monetary position is credited or charged to the statement of profit or
loss.

© Emile Woolf International 530 The Institute of Chartered Accountants of Pakistan

 Chapter 25: Accounting for hyperinflation

4 OTHER ISSUES
Section overview

 Cash flow statement

 Corresponding figures
 Consolidated financial statements
 Economies ceasing to be hyperinflationary
 Disclosures

4.1 Cash flow statement

All items in the cash flow statement must be expressed in terms of the measuring unit current at
the end of reporting period.

4.2 Corresponding figures

Corresponding figures for the previous reporting period must be restated by applying a general
price index so that the comparative financial statements are presented in terms of the measuring
unit current at the end of the reporting period.
Information that is disclosed in respect of earlier periods must also be expressed in terms of the
measuring unit current at the end of the reporting period.
This applies to financial statements based on a historical cost approach and on a current cost
approach.

4.3 Consolidated financial statements

A parent that reports in the currency of a hyperinflationary economy may have subsidiaries that
also report in the currencies of hyperinflationary economies.
The financial statements of any such subsidiary must be restated by applying a general price index
of the country in whose currency it reports before they are included in the consolidated financial
statements issued by its parent.
If the subsidiary is a foreign subsidiary, its restated financial statements are translated at closing
rates.
If financial statements with different reporting dates are consolidated, all items, whether non-
monetary or monetary, need to be restated into the measuring unit current at the date of the
consolidated financial statements.

4.4 Economies ceasing to be hyperinflationary

When an economy ceases to be hyperinflationary, an entity will discontinue the preparation and
presentation of financial statements prepared in accordance with IAS 29.
The amounts expressed in the measuring unit current at the end of the previous reporting period
are used as the basis for the carrying amounts in subsequent financial statements.

4.5 Disclosures
An entity must disclose the following:
 the fact that the financial statements and the corresponding figures for previous periods have
been restated for the changes in the general purchasing power of the functional currency
and, as a result, are stated in terms of the measuring unit current at the end of reporting
period date;
 whether the financial statements are based on a historical cost approach or a current cost
approach; and
 the identity and level of the price index at the end of reporting period date and the movement
in the index during the current and the previous reporting period.

© Emile Woolf International 531 The Institute of Chartered Accountants of Pakistan

Advanced accounting and financial reporting

5 IFRIC 7: APPLYING THE RESTATEMENT APPROACH UNDER IAS 29

Section overview

 Applying the restatement approach under IAS 29

 Deferred taxation

5.1 Applying the restatement approach under IAS 29

In the period in which an entity first identifies the existence of hyperinflation in the economy of its
functional currency, it must apply the requirements of IAS 29 as if the economy had always been
hyperinflationary.
This means that non-monetary items in the opening statement of financial position at the beginning
of the earliest period presented must be restated to reflect the effect of inflation.
 Non-monetary amounts carried at historical cost are restated to reflect inflation form the date
of recognition up to the date of the opening statement of financial position.
 Non-monetary amounts carried at revalued amounts are restated to reflect inflation form the
date of revaluation up to the date of the opening statement of financial position.

Example: Restatement
Extracts of X Limited’s IFRS statement of financial position at 31 December 2017 (before
restatement) are as follows:

2017 2016
Rs. m Rs. m
Non-current assets 300 400

All non-current assets were bought in 2015 (i.e. before that start of the comparative period).
X Limited identified that its functional currency was hyperinflationary in 2017.
X Limited has identified the following price indices and constructed the following
conversion factors:

Price indices
2017 223
2015 95

2017 conversion factor

(2015 prices to 2017 prices) = 223/95 =2.347

This conversion factor must be applied to non-current assets from the 2017 and 2016
financial statements to rebase the figure in terms of 2017 prices.

This results in the following restated amounts:

2017 2015
Rs. m Rs. M
Non-current assets
300  2.347 and 400  2.347 704 939

© Emile Woolf International 532 The Institute of Chartered Accountants of Pakistan

 Chapter 25: Accounting for hyperinflation

5.2 Deferred taxation

Deferred tax is calculated by applying the requirements in IAS 12 to the restated balances.
The comparative deferred tax balance is based on the figure that would have been in last year’s
restated financials adjusted for this year’s price movement.

Example: Restatement – deferred tax

Extracts of X Limited’s IFRS statement of financial position at 31 December 2017 (before
restatement) are as follows:

2017 2016
Rs. m Rs. M
Non-current assets 300 400
Deferred tax liability 30 20

All non-current assets were bought in 2015 (i.e. before that start of the comparative period).

The deferred tax liability was calculated as follows

2017 2016
Rs. m Rs. M
Non-current assets 300 400
Tax base 200 333
Temporary difference 100 67
Tax rate 30% 30%
Deferred taxation 30 20

X Limited identified that its functional currency was hyperinflationary in 2017.

X Limited has identified the following price indices and constructed the following conversion
factors:

Price indices
2017 223
2016 135
2015 95

The following conversion factors are required:

2017 conversion factor (1)

(2015 prices to 2017 prices) = 223/95 =2.347

Used to restate non-current assets (as before)

2017 conversion factor (2)

(2016 prices to 2017 prices) = 223/135 = 1.652

Used to restate the deferred tax balance that would have been measured in 2016
if restated financial statements had been prepared into 2017 prices.

2016 conversion factor (3)

(2015 prices to 2016 prices) = 135/95 =1.421

© Emile Woolf International 533 The Institute of Chartered Accountants of Pakistan

Advanced accounting and financial reporting

Example: Restatement – deferred tax (continued)

Used to restate non-current assets to 2016 prices in order to calculate the deferred tax balance
that would have been measured in 2016 if restated financial statements had been prepared.

The 2017 conversion factor (1) is applied to non-current assets from the 2017 and 2016
financial statements to restate the figure in terms of 2017 prices (as before):

2017 2016
Rs. m Rs. m
Non-current assets
300  2.347 and 400  2.347 704 939

The deferred tax liability as at 31 December 2017 is calculated as follows:

2017
Rs. m
Non-current assets 704
Tax base 200
Temporary difference 504
Tax rate 30%
Deferred taxation 151

The 2017 comparative deferred tax liability is

calculated as follows:

2016
Rs. m
Non-current assets (rebased to 2016 prices using
the 2016 conversion factor (3)
400  1.421 568
Tax base 333
Temporary difference 235
Tax rate 30%
Deferred taxation 71
Rebase to 2017 prices using the 2017 conversion
factor (2)  1.652
Tax at 30% 117

The restated deferred tax balances are as follows:

2017 2015
Rs. m Rs. m
Non-current assets
300  2.347 and 400  2.347 704 939

© Emile Woolf International 534 The Institute of Chartered Accountants of Pakistan

 Certified Finance and Accounting Professional

26

CHAPTER
Advanced accounting and financial reporting

Islamic accounting standards

Contents
1 Islamic accounting standards

© Emile Woolf International 535 The Institute of Chartered Accountants of Pakistan

Advanced accounting and financial reporting

1 ISLAMIC ACCOUNTING STANDARDS

Section overview

 Introduction to Islamic finance

 IFAS 1: Murabaha
 IFAS 2: Ijarah
 IFAS on profit and loss sharing deposits

1.1 Introduction to Islamic finance

Note that the Islamic Finance Resource is an excellent website full of useful information and
examples. It is recommended that you visit the site (http://ifresource.com).
The main principles of Islamic finance are that:
 Wealth must be generated from legitimate trade and asset-based investment (the use of
money for the purposes of making money is expressly forbidden).
 Investment should have a social and an ethical benefit to wider society beyond pure return.
 Risk should be shared.
 Harmful activities (haram) should be avoided.
The intention is to avoid injustice, asymmetric risk and moral hazard (where the party who causes
a problem does not suffer its consequences) and unfair enrichment at the expense of another
party.
Permitted activities
Islamic banks are allowed to obtain their earnings through profit-sharing investments or fee-based
returns. If a loan is given for business purposes, the lender should take part in the risk. This usually
involves the lender buying the asset and then allowing a customer to use the asset for a fee.
Specific guidance
The following activities are prohibited:
 Charging and receiving interest (riba).
 Charging interest contradicts the principle that risk must be shared and is also
contrary to the ideas of partnership and justice.
 Using money to make money is forbidden.
 Investment in companies that have too much borrowing is also prohibited. What
constitutes “too much borrowing” is a matter for interpretation but is typically defined
as debt totalling more than 33% of the stock market value over the last 12 months.
 Investments in businesses involved in alcohol, gambling, or anything else that the Shariah
considers unlawful or undesirable (haram).
 Investments in transactions that involve speculation or extreme risk. (This is seen as
gambling).
 Entering into contracts where there is uncertainty about the subject matter and terms of
contracts (This includes a prohibition on short selling, i.e. selling something is not yet
owned).
Financial institutions in Islamic countries face the problem of providing finance in ways which do
not contravene the injunctions of Shariah regarding riba or interest.
There are a number of Shariah compliant financing methods which have become widely used. The
absence of guidance on how to account for these products has led to diversity in practice thus
reducing the usefulness of financial statements.
ICAP has produced several Islamic Financial Accounting Standards (IFAS) to provide appropriate
guidance with the aim of improving comparability of financial statements.

© Emile Woolf International 536 The Institute of Chartered Accountants of Pakistan

 Chapter 26: Islamic accounting standards

1.2 IFAS 1: Murabaha

Introduction
The ideal mode of financing according to Shariah would be mudarabah or musharakah.

Definitions
Mudarabah
Mudarabah is a partnership in profit whereby one party provides capital (rab al maal) and the other
party provides labour (mudarib).
In the context of lending, the bank provides capital and the customer provides expertise to invest
in a project. Profits generated are distributed according in a pre-determined ratio but cannot be
guaranteed. The bank does not participate in the management of the business. This is like the bank
providing equity finance.
The project might make a loss. In this case the bank loses out. The customer cannot be made to
compensate the bank for this loss as that would be contrary to the mutual sharing of risk.
Musharakah
Relationship established under a contract by the mutual consent of the parties for sharing of profits
and losses arising from a joint enterprise or venture.
This is a joint venture or investment partnership between two parties who both provide capital
towards the financing of new or established projects. Both parties share the profits on a pre-agreed
ratio, allowing managerial skills to be remunerated, with losses being shared on the basis of equity
participation.

It is difficult to use mudarabah and musharakah instruments in every type of financing.

Murabaha may be used as a form of providing but should be restricted only to those cases where
the mudarabah and musharakah are not practicable.
Murabaha
In traditional western finance a customer would borrow money from a bank in order to finance
activity, say the purchase of an asset. However, under Sharia the bank cannot charge interest.
Murabaha is a form of trade credit for asset acquisition that avoids the payment of interest. The
bank buys the asset and then sells it on to the customer on a deferred basis at a price that includes
an agreed mark-up for profit. Payment can be made by instalments but the mark-up is fixed in
advance and cannot be increased, even if there is a delay in payment.

Definition
Murabaha: Murabaha is a particular kind of sale where seller expressly mentions the cost he has
incurred on the commodities to be sold and sells it to another person by adding some profit or
mark-up thereon which is known to the buyer.
Thus, murabaha is a cost plus transaction where the seller expressly mentions the cost of a
commodity sold and sells it to another person by adding mutually agreed profit thereon which can
be either in lump-sum or through an agreed ratio of profit to be charged over the cost.

Compliance with Sharia

A loan transaction is not made Shariah compliant by simply changing the term interest or markup
in a contract to profit. A murabaha transaction must satisfy basic conditions as laid down in
Shariah.
A Murabaha transaction is not valid under Shariah unless the subject of the transaction is:
 in existence; and
 owned by the seller; and
 in the physical or constructive possession of the seller.

© Emile Woolf International 537 The Institute of Chartered Accountants of Pakistan

Advanced accounting and financial reporting

The following conditions also apply:

 The sale must be prompt and absolute. Thus a sale attributed to a future date or a sale
contingent on a future event is void.
 The subject matter of sale must be a property of value and must be specifically known and
identified to the buyer.
 The subject matter of sale cannot be a thing which is forbidden (Haram) by Shariah.
There are further principles regarding deferred payment.
 A sale in which the parties agree that the payment of price is deferred is called a Bai'mu'ajjal.
 Bai'mu'ajjal is valid if the price and due date of payment is fixed in an unambiguous manner.
 The due time of payment can be fixed either with reference to a particular date, or by
specifying a period of time, but it cannot be fixed with reference to a future event, the exact
date of which is unknown or is uncertain. If the time of payment is unknown or uncertain, the
sale is void.
 If a particular period (e.g. one month) is fixed for payment, the period is deemed to start at
the date of delivery unless the parties have agreed otherwise.
 A deferred price may be more than the cash price, but it must be fixed at the time of sale.
Further comment on the structure of a Shariah compliant transaction
A bank may purchase the commodity and keep it in its own possession prior to selling it or it could
purchase the commodity through a third person appointed by it as an agent.
A bank is also allowed to appoint the customer in the murabaha transaction as its agent.
In this case the customer (who will eventually buy the commodity from the bank) first purchases
the commodity and takes possession of it on behalf of the bank and then later buys it from the
bank.
The following procedure can be used to accomplish a deal like the one above in a way that is
compliant with Shariah:
 The client and the bank sign an agreement under which the bank promises to sell and the
client promises to buy commodity up to a maximum amount of purchases at an agreed profit
margin.
 The bank appoints the client as his agent for purchasing the commodity on its behalf.
 The client purchases the commodity on behalf of the bank and takes its possession as an
agent of the bank.
 The client informs the bank that the commodity has been purchased for the bank and is in
the client’s possession. (The client is an agent of the bank thus the bank has constructive
possession of the commodity).
 The client (at the same time) makes an offer to purchase the commodity from the bank at
the agreed profit margin referred to above.
 The bank accepts the offer and raises an invoice for the sale. Ownership as well as the risk
of the commodity is transferred to the client.
Standard Accounting Practice
IFAS 1 applies to murabaha transactions undertaken by a bank in historical cost financial
statements.
Cost of inventories should comprise all costs of purchases and other costs incurred in bringing the
inventories to their present location and condition.
Inventories remaining unsold with the bank at the reporting date are inventories of the bank and
must be valued in accordance with IAS 2 and shown under other assets.
The information required by IAS 2 should be disclosed.

© Emile Woolf International 538 The Institute of Chartered Accountants of Pakistan

 Chapter 26: Islamic accounting standards

Murabaha receivables must be recorded at the invoiced amounts.

Purchases and sales and the resulting profit are accounted for at the conclusion of a Murabaha
transaction.
Profit on that portion of sales not due for payment should be deferred by debiting to unearned
murabaha income and crediting deferred murabaha income which should be shown as a
liability.

1.3 IFAS 2: Ijarah

Ijarah are leases that are Shariah compliant.
The objective of IFAS 2 is to prescribe the accounting treatment and required disclosures for
lessees and lessors in respect of ijarah.
IFAS 2 does not apply to:
 lease agreements to explore for or use minerals, oil, natural gas and similar non-
regenerative resources;
 licensing agreements for such items as motion picture films, video recordings, plays,
manuscripts, patents and copyrights;
 lessors of investment property leased out under operating leases; and
 lessors of biological assets leased out under operating leases.
Compliance with Sharia (the Shariah essentials)
The following characteristics are necessary for a lease to be compliant with Shariah:
 In Ijara/leasing, the asset that is the subject of the lease remains in the ownership of the
lessor and only its usufruct is transferred to the lessee.
 Only owned assets can be leased out except that a lessee can effect a sub-lease with the
express permission of the lessor.
 Any asset that cannot be used without being consumed cannot be a leased asset (e.g
money, edibles, fuel, etc.).
 Lease rentals do not become due and payable until the assets to be leased are delivered to
the lessee.
 The lessor must retain title to the asset and bear all risks and rewards pertaining to
ownership during the entire term of the lease. However, the lessee is responsible for any
damage or loss caused to the leased asset due to the fault or negligence of the lessee or
from non-customary use of the asset and is also responsible for all risks and consequences
in relation to third party liability, arising from or incidental to operation or use of the leased
assets.
 The insurance of the leased asset should be in the name of lessor and the cost of such
insurance borne by him.
 A lease can be terminated before expiry of the term of the lease but only with the mutual
consent of the parties.
 Either party can make a unilateral promise to buy/sell the assets upon expiry of the term of
lease, or earlier at a price and at such terms and conditions as are agreed. However, the
lease agreement cannot be conditional upon such a sale nor can the lease agreement
contain a term agreeing to transfer of ownership at a future date.
 The amount of rental must be agreed in advance in an unambiguous manner either for the
full term of the lease or for a specific period in absolute terms.
 A lease contract of is considered terminated if the leased asset ceases to give the service
for which it was rented.

© Emile Woolf International 539 The Institute of Chartered Accountants of Pakistan

Advanced accounting and financial reporting

Definitions
Ijarah is a form of lease finance agreement where a bank buys an asset for a customer and then
leases it to the customer over a specific period for agreed rentals which allow the bank to recover
the capital cost of the asset and a profit margin.

Definition: Ijarah (Lease)

Ijarah is a contract whereby the owner of an asset, other than consumables, transfers its usufruct
to another person for an agreed period for an agreed consideration.
Usufruct: The right to use an asset.

The term ijarah also includes a contract of sublease executed by the lessee with the express
permission of the lessor (being the owner).
Whether a transaction is an ijarah or not depends on its substance rather than the form of the
contract provided it complies with the Shariah essentials (as shown above).
An ijarah is an agreement that is cancellable only:
 upon the occurrence of some remote contingency such as force majeure;
 with the mutual consent of the muj’ir (lessor) and the musta’jir (lessee); or
 If the musta’jir (lessee) enters into a new ijarah for the same or an equivalent asset with the
same muj’ir (lessor).

Definitions
Inception of the ijarah: The date the leased asset is put into musta’jir’s (lessee’s) possession
pursuant to an ijarah contract.
The term of the ijarah: The period for which the musta’jir (lessee) has contracted to lease the asset
together with any further terms for which the musta’jir (lessee) has the option to continue to lease
the asset, with or without further payment, which option at the inception of the ijarah it is
reasonably certain that the musta’jir (lessee) will exercise.
Ujrah (lease) payments: Payments over the ijarah term that the musta’jir is, contractually required
to pay.
Economic life: Either the period over which an asset is expected to be economically usable by one
or more users or the number of production or similar units expected to be obtained from the asset
by one or more users.
Useful life: The estimated period, from the beginning of the ijarah term, without limitation by the
ijarah term, over which the economic benefits embodied in the asset are expected to be consumed
by the enterprise.

Ijarah in the financial statements of musta’jir (lessees)

Assets acquired for ijarah are recognised upon acquisition at historical cost which is the net
purchasing price plus all expenditures necessary to bring the asset to its intended use, such as
custom duties, taxes, freight, insurance, installation, testing, etc.
Ujrah payments under an ijarah should be recognised as an expense in the statement of profit or
loss on a straight-line basis over the ijarah term unless another systematic basis is representative
of the time pattern of the user’s benefit.
Ujrah payments are recognised as an expense in the statement of profit or loss on a straight- line
basis unless another systematic basis is representative of the time pattern of the user’s benefit,
even if the payments are not on that basis.
Musta’jir (Lessees) should make the following disclosures for ijarah, in addition to meeting the IFRS
disclosure requirements in respect of financial instruments:
 the total of future ujrah payments under ijarah, for each of the following periods:
 not later than one year;
 later than one year and not later than five years;
 later than five years;

© Emile Woolf International 540 The Institute of Chartered Accountants of Pakistan

 Chapter 26: Islamic accounting standards

 the total of future sub-ijarah payments expected to be received under sub-ijarah at the
reporting date;
 ijarah and sub-ijarah payments recognised in income for the period, with separate amounts
for ijarah payments and sub-ijarah payments;
 a general description of the musta’jir’s (lessee’s) significant ijarah arrangements including,
but not limited to restrictions imposed by ijarah arrangements, such as those concerning
dividends, additional debt, and further ijarah.
ijarah in the financial statements of muj’ir (lessors)
Muj’ir (lessors) should present assets subject to ijarah in their statement of financial position
according to the nature of the asset, distinguished from the assets in own use.
Ijarah income from Ijarah should be recognised in income on accrual basis as and when the rental
becomes due, unless another ~ systematic basis is more representative of the time pattern in which
benefit of use derived from the leased asset is diminished.
Costs, including depreciation, incurred in earning the ijarah income are recognised as an expense.
Ijarah income is recognised in income on accrual basis as and when the rental becomes due,
unless another systematic basis is more representative of the time pattern in which use benefit
derived from the leased asset is diminished.
Initial direct costs incurred specifically to earn revenues from an ijarah are either deferred and
allocated to income over the ijarah term in proportion to the recognition of ujrah, or are recognised
as an expense in the statement of profit or loss in the period in which they are incurred.
Assets leased out should be depreciated over the period of lease term using depreciation methods
set out in lAS 16 However, in the event of an asset expected to be available for re-ijarah after its
first term, depreciation should be charged over the economic life of such asset on the basis set out
in IAS 16.
Muj’ir (Lessors) should make the following disclosures for ijarah, in addition to meeting the IFRS
disclosure requirements in respect of financial instruments:
 the future ijarah payments in the aggregate and for each of the following periods:
 not later than one year;
 later than one year and not later than five years;
 later than five years; and
 a general description of the muj’ir (lessor’s) significant leasing arrangements.
In addition, the requirements on disclosure under IAS 16: Property, plant and equipment, IAS 36:
Impairment of assets, IAS 38: Intangible assets and IAS 40: Investment property, apply to assets
leased out under ijarah.
Sale and leaseback transactions
A sale and leaseback transaction involves the sale of an asset by the vendor and the leasing of
the same asset back to the vendor.
When an asset is sold with an intention to enter into an ijarah arrangement, any profit or loss based
on the asset’s fair value should be recognised immediately.
If the sale price is below fair value, any profit or loss should be recognised immediately except that,
if the loss is compensated by future lease payments at below market price, it should be deferred
and amortised in proportion to the lease payments over the period for which the asset is expected
to be used.
If the sale price is above fair value, the excess over fair value should be deferred and amortised
over the period for which the asset is expected to be used.

© Emile Woolf International 541 The Institute of Chartered Accountants of Pakistan

Advanced accounting and financial reporting

1.4 IFAS on profit and loss sharing deposits

Financial institutions establish and manage funds for investment. Investors contribute to the funds
and share in the profit or loss of the fund. This is the return on the investments made using the
assets of the fund less the financial institutions management fee.
Each investor owns a share of the fund determined by his investment. The financial institution must
keep records comprising individual accounts for each investor which shows the balance on the
account that belongs to the investor (investment account holder).
Some funds are set up with limitations on the type of investments that can be made by the financial
institution on behalf of the investors. Other funds are set up without such limitations. These funds
are said to be unrestricted.
This standard provides guidance on accounting principles to be followed by Institutions offering
Islamic Financial Services (IIFS). The guidance covers recognition, measurement, presentation
and disclosure in respect of transactions relating to equity (funds) of unrestricted investment /
(Profit/Loss Sharing) PLS deposit account holders and their equivalents (unrestricted funds) in
which the IIFS is acting as mudarib.
The standard only deals with funds which in effect are mudaraba or musharaka contracts. These
definitions are repeated here for your convenience.

Definitions
Mudaraba
Mudaraba is a partnership in profit whereby one party provides capital (rab al maal) and the other
party provides labour (mudarib). (Mudarib may also contribute capital with the consent of the rab
al maal).
Musharaka
Relationship established under a contract by the mutual consent of the parties for sharing of profits
and losses arising from a joint enterprise or venture.

The standard does not address the following:

 The funds received by the IIFS on a basis other than mudaraba or musharaka contracts.
 Bases of calculation of Zakat on funds within the scope of the standard.
The standard addresses two issues:
 The accounting principles relating to funds received by the IIFS for investment in its capacity
as a mudarib at the IIFS's discretion, in whatever manner the IIFS deems appropriate
(unrestricted funds); and
 the disclosure of bases for profit allocation between owners' equity and that of unrestricted
funds.
Definitions

Definition
Unrestricted investment accounts / PLS deposit accounts (unrestricted funds)
Accounts where the investment account holder authorises the IIFS to invest the account holder’s
funds on the basis of Mudaraba or Musharaka contract in a manner which the IIFS deems
appropriate without laying down any restrictions as to where, how and for what purpose the funds
should be invested.
The IIFS might also use other funds which it has the right to use with the permission of Investment
account holders.

The investment account holder authorises the IIFS to invest the account holder’s funds on the
basis of mudaraba or musharaka contract as IIFS deems appropriate without laying down any
restrictions as to where, how and for what purpose the funds should be invested.

© Emile Woolf International 542 The Institute of Chartered Accountants of Pakistan

 Chapter 26: Islamic accounting standards

The IIFS can commingle the investment account holder’s funds with its own equity or with other
funds that it has the right to use with the permission of Investment account holders.
Holders of investment accounts appoint IIFS to invest their funds on the basis of an agency contract
in return for a specified fee and perhaps a specified share of the profit if the realised profit exceeds
a certain level.
Profits (calculated after the IIFS has received its share of profits as a mudarib) are allocated
between investment account holders and the IIFS according to relative amount of funds invested
and a pre-agreed profit sharing formula.
Losses are allocated between the investment account holders and the IIFS based on the relative
amount of funds invested by each.
Accounting treatment in respect of unrestricted investment account holders / PLS deposit account
holders

Definition
Funds of unrestricted investment/PLS deposit account holders
The balance, at the reporting date, from the funds originally received by the IIFS from the account
holders plus (minus) their share in the profits (losses) and decreased by withdrawals or transfers to
other types of accounts.

Funds of the account holders are initially measured as the amount invested and the subsequently
measured as follows at each reporting date:

Illustration:

Balance of investment account at the beginning of the period X

Add: Any further deposits X
Less: Any withdrawals (X)
Add: Any share of profits allocated and reinvested X
Less: Any share of losses allocated (X)
Add / less: Any other necessary adjustment. X/(X)
X

Profits of investments jointly financed by the investment account holders and the IIFS are allocated
between them according to the mutually agreed terms.
Profits which have been allocated but have not yet been repaid or reinvested must be recognised
and disclosed as a liability by the IIFS.
Any loss resulting from transactions in a jointly financed investment is accounted as follows:
 as a deduction from any unallocated profits; then
 any loss remaining should be deducted from provisions for investment losses set aside for
this purpose; then
 any remaining loss should be deducted from the respective equity shares in the joint
investment account holders and the IIFS according to each party’s investment for the period.
A loss due to negligence or similar on the part of the IIFS is deducted from its share of the profits
of the jointly financed investment. Any such loss in excess of the IIFS's share of profits is deducted
from its equity share in the joint investment.
Presentation and disclosure in financial statements
Funds of account holders must be accounted for as redeemable capital.
The financial statement must disclose the following in its note on significant accounting policies:

© Emile Woolf International 543 The Institute of Chartered Accountants of Pakistan

Advanced accounting and financial reporting

 the bases applied to allocate profits between owners' equity and the account holders;
 the bases applied by the IIFS for charging expenses to unrestricted account holders;
 the bases applied by the IIFS for charging provisions, such as provision for non performing
accounts, provisions on impairment etc and the parties to whom they revert once they are
no longer required.
The IIFS should disclose significant category of accounts and of the percentage which the IIFS has
agreed to invest in order to produce returns for them.
Disclosure should be made of the aggregate balances of all unrestricted funds (and their
equivalent) classified as to type and also in terms of local and foreign currency.
The following disclosures should be made either in the notes to the financial statements or a
separate statement:
 the total administrative expenses charged in respect of unrestricted funds with a brief
description of their major components;
 details of profit allocation between owner's equity investment account holders applied in the
current financial period;
 the percentage of profit charged by the IIFS as a mudarib during the financial period;
 where the IIFS is unable to utilise all funds available for investment how the investments
made relates to the IIFS and investment account holders.
The following disclosures should also be made:
 the bases and the aggregate amounts (if applicable) for determining incentive profits which
IIFS receives from the profits of unrestricted funds and incentive profits which IIFS pays from
its profits to investment account holders;
 concentration of sources of investment accounts;
 maturity profile of the unrestricted investment funds.
Disclosure should be made of sources of financing of material classes of assets showing
separately those:
 exclusively financed by investment account holders;
 exclusively financed by IIFS; and
 jointly financed by IIFS and investment account holders.
The rights, conditions and obligations of each class of investment account holders shown in the
statement of financial position should be disclosed.
Separate disclosures must be made of all material items of revenues, expenses, gains and losses
classified under the headings appropriate to the IIFS distinguishing those attributable to investment
accounts, IIFS, and IIFS and investment account holders jointly.

© Emile Woolf International 544 The Institute of Chartered Accountants of Pakistan

 Certified Finance and Accounting Professional

27

CHAPTER
Advanced accounting and financial reporting

Professional ethics

Contents
1 The fundamental principles
2 Conflict of interest
3 Section 220: Preparation and Presentation of information

© Emile Woolf International 545 The Institute of Chartered Accountants of Pakistan

Advanced Accounting and Financial Reporting

1 THE FUNDAMENTAL PRINCIPLES

Section overview

 Introduction
 The fundamental principles of the ICAP Code of Ethics
 The conceptual framework

1.1 Introduction
Chartered Accountants are expected to demonstrate the highest standards of professional conduct
for public interest. Ethical behavior by Chartered Accountants plays a vital role in ensuring public
trust in financial reporting and business practices and upholding the reputation of the accountancy
profession.
ICAP’s Code of Ethics for Chartered Accountants (Revised 2019) helps members of the Institute
meet these obligations by providing them with ethical guidance. The Code applies to all members,
students, affiliates, employees of member firms and, where applicable, member firms, in all of their
professional and business activities, whether remunerated or voluntary.
Students are advised to study primarily from original book of ICAP’s Code of Ethics for Chartered
Accountants (Revised 2019) and refer to this chapter as a supplementary study material.

1.2 The fundamental principles of the ICAP Code of Ethics

A chartered accountant shall comply with each of the five fundamental principles of the Code set
out below.

Principle Explanation
Integrity A professional accountant should be straightforward and honest in all
professional and business relationships.
Objectivity A professional accountant should not allow bias, conflict of interest or undue
influence of others to override his or her professional or business judgements.
Professional A professional accountant has a continuing duty to maintain professional
competence knowledge and skill at the level required to ensure that a client or employer
and due care receives competent professional service based on current technical and
professional standards and relevant legislation. A professional accountant
should act diligently and in accordance with applicable technical and
professional standards when providing professional services or working for an
employer.
Confidentiality A professional accountant should respect the confidentiality of information
acquired as a result of professional or business relationships and should not
disclose any such information to third parties without proper and specific
authority unless there is a legal or professional right or duty to disclose.
Confidential information should not be used for the personal advantage of the
professional accountant or third parties.
Professional A professional accountant should comply with relevant laws and regulations
behaviour and should avoid any action or conduct which discredits the profession.

You need to know these five fundamental principles and what each of them means. An exam
question may require you to discuss the relevance of the five fundamental principles to a particular
situation in a case study.

© Emile Woolf International 546 The Institute of Chartered Accountants of Pakistan

 Chapter 27: Professional ethics

1.3 The conceptual framework

The application of the fundamental principles set out above is considered by the ICAP Code within
a conceptual framework. This framework, applies to chartered accountants in business and in
practice, acknowledges that these principles may be threatened in a broad range of circumstances.
A chartered accountant shall apply this conceptual framework to:
a) Identify threats to compliance with the fundamental principles;
b) Evaluate the threats identified; and
c) Address the threats by eliminating or reducing them to an acceptable level.
This chapter covers only the professional accountants in business (PAIB)* which are engaged in
an executive or non-executive capacity in such areas as commerce, industry, the public and service
sectors (including public sector bodies), education, the not for profit sector, regulatory bodies or
professional bodies. A PAIB may be a salaried employee, a director (whether executive or non-
executive), an owner manager or another working for one or more employing organisations. The
legal form of the relationship with the employing organisation, if any, has no bearing on the ethical
responsibilities incumbent on the professional accountant in business*.
Exercise of Professional Judgment
CAs are required to exercise professional judgement in undertaking all professional activities. In
exercising professional judgement, CAs apply their relevant training, professional knowledge, skill
and experience. CAs might consider below factors in exercising professional judgement:
 Reason to be concerned that potentially relevant information might be missing from the
known facts and circumstances
 Inconsistency between the known facts and circumstances and CAs’ expectations.
 CAs’ expertise and experience are sufficient to reach a conclusion.
 Need to consult with others with relevant expertise or experience.
 The information provides a reasonable basis on which to reach a conclusion.
 Preconception or bias might affect the exercise of professional judgment.
 Other reasonable conclusions could be reached from the available information.
Threats to the fundamental principles fall into one or more of the following categories:
 Self-interest threat. This arises when the accountant has a financial or other interest in a
matter. Typically, this means that the accountant’s decisions may be influenced by self-
interest and the accountant will therefore not act with objectivity and independence.

Examples of potential self-interest threat

 financial interests, loans or guarantees from the employer
 incentive-based compensation offered by the employer
 inappropriate personal use of corporate assets
 offered a gift or special treatment from a supplier
 concern over employment security
 commercial pressure from outside the employing organization

 Self-review threat. This occurs when an accountant is required to review or re-evaluate (for
a different purpose) a previous judgement they have made or action that they have taken.

Examples of potential self-review threat

 determining the appropriate accounting treatment for a business combination after performing
the feasibility study supporting the purchase decision.

© Emile Woolf International 547 The Institute of Chartered Accountants of Pakistan

Advanced Accounting and Financial Reporting

 business decisions or data being reviewed by the same person who made those decisions or
prepared that data.
 being in a position to exert direct and significant influence over an entity’s financial reports.
 the discovery of a significant error during a re-evaluation of the work undertaken by the
member.

 Advocacy threat. This occurs when the accountant is in a position or option to the point that
subsequent objectivity may be compromised. This would be a threat to objectivity and
independence.
Examples of potential advocacy threat
 opportunity to manipulate information in a prospectus in order to obtain favorable financing.
 commenting publicly on future events.
 situations where information is incomplete or where the argument being supported is against
the law.

 Intimidation threat. This occurs when members may be deterred from acting with
objectivity due to threats, actual or perceived, against them.

Examples of potential intimidation threat

 threat of dismissal or replacement of the member, or a close family member, over a
disagreement about the application of an accounting principle or the way in which information
is to be reported.
 a dominant personality attempting to influence the member’s decisions e.g. regarding the
awarding of contracts or the application of accounting principles.

 Familiarity threat. This occurs when the accountant becomes too sympathetic with others
due to close relationships, for example being responsible for the employing organisation’s
financial reporting when an immediate or close family member employed by the entity makes
decisions that affect the entity’s financial reporting.

Examples of potential familiarity threat

 accepting a gift or preferential treatment, unless the value is trivial and inconsequential.
 long association with business contacts influencing business decisions.

CAs are required to identify, evaluate and respond to such threats. If identified threats are
significant, they must implement safeguards to eliminate the threats or reduce them to an
acceptable level so that compliance with the fundamental principles is not compromised.
CAs shall do so by:
1. Eliminating the circumstances, including interests or relationships, that are creating the
threats;
2. Applying safeguards, where available and capable of being applied, to reduce the threats
to an acceptable level; or
3. Declining or ending the specific professional activity.
EXAM TECHNIQUE POINT
In any scenario-based question regarding the five fundamental principles or any of the situations
causing the five threats to independence, it is important to not only state the basic requirements
of the code that are being breached but also relate them to scenario given.
Also, it helps to give some commentary in relation to the significance of a threat i.e. if the situation
relates to a more senior person on the audit firm (such as the Engagement Partner) the threat is
likely to be significant, with no safeguards being able to eliminate or reduce it to acceptable levels.

© Emile Woolf International 548 The Institute of Chartered Accountants of Pakistan

 Chapter 27: Professional ethics

2 CONFLICT OF INTEREST
A conflict of interest creates threats to compliance with the principle of objectivity and might create
threats to compliance with the other fundamental principles. Such threats might be created when:
(a) A chartered accountant undertakes a professional activity related to a particular matter for two or
more parties whose interests with respect to that matter are in conflict; or
(b) The interest of a chartered accountant with respect to a particular matter and the interests of a
party for whom the accountant undertakes a professional activity related to that matter are in
conflict.

Examples of circumstances that might create a conflict of interest include:

 Serving in a management or governance position for two employing organizations and
acquiring confidential information from one organization that might be used by the chartered
accountant to the advantage or disadvantage of the other organization.
 Undertaking a professional activity for each of two parties in a partnership, where both parties
are employing the accountant to assist them to dissolve their partnership.
A CA should take reasonable steps to identify circumstances that might create a conflict of interest, and
therefore a threat to compliance with any of the fundamental principles:
Safeguards to address threats created by conflicts of interest include:
 Restructuring or segregating certain responsibilities and duties.
 Obtaining appropriate oversight, for example, acting under the supervision of an executive or non-
executive director.
Disclosure and consent
A CA is required to exercise professional judgement to determine whether specific disclosure and explicit
consent are necessary to mitigate the threat created by the conflict of interest. Disclosures might be
“General”, such as a common commercial practice by the CA or “Specific” to the circumstances of the
particular conflict.
Members are encouraged to make disclosure or consent in writing. However, if these are not in writing, a
CA should sufficiently document the nature of the circumstances, safeguards applied, and consents
obtained.

© Emile Woolf International 549 The Institute of Chartered Accountants of Pakistan

Advanced Accounting and Financial Reporting

3 SECTION 220: PREPARATION AND PRESENTATION OF INFORMATION

Section overview

 Professional Accountants in Business(PAIBs)

 Preparation and Presentation of Information

3.1 Professional Accountants in Business (PAIBs)

Professional Accountants in business are often responsible for the preparation of accounting
information.
PAIBs need to ensure that they do not prepare financial information in a way that is misleading or
that does not show a true and fair view of the entity’s operations.
PAIBs who are responsible for the preparation of financial information must ensure that the
information they prepare is technically correct, reports the substance of the transaction and is
adequately disclosed.
There is a danger of influence from senior managers to present figures that inflate profit or assets
or understate liabilities. This puts the accountant in a difficult position. On one hand, they wish to
prepare proper information and on the other hand, there is a possibility they might lose their job if
they do not comply with their managers’ wishes.
In this case, ethics starts with the individual preparing the information. They have a difficult decision
to make; whether to keep quiet or take the matter further. If they keep quiet, they will certainly be
aware that they are not complying with the ethics of the accounting body they belong to. If they
speak out, they may be bullied at work into changing the information or sacked.

3.2 Preparation and Presentation of Information

Chartered accountants in business at all levels are often involved in the preparation and
presentation of information that may either be made public or used by others inside or outside the
employing organisation including:
 Management and those charged with governance.
 Investors and lenders or other creditors.
 Regulatory bodies.
Such information may include financial or management information, for example:
 Operating and performance reports.
 Decision support analysis.
 Forecasts and budgets;
 Information provided to the internal and external auditors.
 Risk analyses.
 General and special purpose financial statements.
 Tax returns.
 Reports filed with regulatory bodies for legal and compliance purposes.

© Emile Woolf International 550 The Institute of Chartered Accountants of Pakistan

 Chapter 27: Professional ethics

When preparing or presenting information, a chartered accountant shall:

 Prepare or present the information in accordance with a relevant reporting framework, where
applicable;
 Prepare or present the information in a manner that is intended neither to mislead nor to
influence contractual or regulatory outcomes inappropriately;
 Exercise professional judgment to:
 Represent the facts accurately and completely in all material respects;
 Describe clearly the true nature of business transactions or activities;
 Classify and record information in a timely and proper manner; and
 Not omit anything with the intention of rendering the information misleading or of
influencing contractual or regulatory outcomes inappropriately.
Use of Discretion in Preparing or Presenting Information

Preparing or presenting information might require the exercise of discretion in making professional
judgments. The chartered accountant shall not exercise such discretion with the intention of
misleading others or influencing contractual or regulatory outcomes inappropriately.

Examples of ways in which discretion might be misused to achieve inappropriate outcomes include:

 Determining estimates, for example, determining fair value estimates in order to

misrepresent profit or loss.
 Selecting or changing an accounting policy or method among two or more alternatives
permitted under the applicable financial reporting framework, for example, selecting a policy
for accounting for long- term contracts in order to misrepresent profit or loss.
 Determining the timing of transactions, for example, timing the sale of an asset near the end
of the fiscal year in order to mislead.
 Determining the structuring of transactions, for example, structuring financing transactions
in order to misrepresent assets and liabilities or classification of cash flows.
 Selecting disclosures, for example, omitting or obscuring information relating to financial or
operating risk in order to mislead.
When performing professional activities, especially those that do not require compliance with a
relevant reporting framework, the chartered accountant shall exercise professional judgment to
identify and consider:

(a) The purpose for which the information is to be used;

(b) The context within which it is given; and
(c) The audience to whom it is addressed.
For example, when preparing or presenting pro forma reports, budgets or forecasts, the inclusion
of relevant estimates, approximations and assumptions, where appropriate, would enable those
who might rely on such information to form their own judgments.

The chartered accountant might also consider clarifying the intended audience, context and
purpose of the information to be presented.
Relying on the Work of Others

A chartered accountant who intends to rely on the work of others, either internal or external to the
employing organization, shall exercise professional judgment to determine what steps to take, if
any, in order to fulfill his responsibilities

© Emile Woolf International 551 The Institute of Chartered Accountants of Pakistan

Advanced Accounting and Financial Reporting

Factors to consider in determining whether reliance on others is reasonable include:

 The reputation and expertise of, and resources available to, the other individual or
organization.
 Whether the other individual is subject to applicable professional and ethics standards.
Such information might be gained from prior association with, or from consulting others about, the
other individual or organization.
Addressing Information that is or might be misleading

When the chartered accountant knows or has reason to believe that the information with which the
accountant is associated is misleading, the accountant shall take appropriate actions to seek to
resolve the matter including:
 Discussing concerns that the information is misleading with the chartered accountant’s
superior and/or the appropriate level(s) of management within the accountant’s employing
organization or those charged with governance, and requesting such individuals to take
appropriate action to resolve the matter. Such action might include:
 Having the information corrected.
 If the information has already been disclosed to the intended users, informing them of
the correct information.
 Consulting the policies and procedures of the employing organization (for example, an ethics
or whistle-blowing policy) regarding how to address such matters internally.
The chartered accountant might determine that the employing organization has not taken
appropriate action. If the accountant continues to have reason to believe that the information is
misleading, the following further actions might be appropriate provided that the accountant remains
alert to the principle of confidentiality:
Consulting with:
 A relevant professional body.
 The internal or external auditor of the employing organization.
 Legal counsel.
 Determining whether any requirements exist to communicate to: 
 Third parties, including users of the information.
 Regulatory and oversight authorities.
If after exhausting all feasible options, the chartered accountant determines that appropriate action
has not been taken and there is reason to believe that the information is still misleading, the
accountant shall refuse to be or to remain associated with the information.
In such circumstances, it might be appropriate for a chartered accountant to resign from the
employing organization.
Documentation

The chartered accountant is encouraged to document:

 The facts.
 The accounting principles or other relevant professional standards involved.
 The communications and parties with whom matters were discussed.
 The courses of action considered.
 How the accountant attempted to address the matter(s).


© Emile Woolf International 552 The Institute of Chartered Accountants of Pakistan

 Chapter 27: Professional ethics

Illustration 01:
Ibrahim is member of ICAP working as a unit accountant.
He is a member of a bonus scheme under which, staff receive a bonus of 10% of their annual salary
if profit for the year exceeds a trigger level.
Ibrahim has been reviewing working papers prepared to support this year’s financial statements.
He has found a logic error in a spreadsheet used as a measurement tool for provisions.
Correction of this error would lead to an increase in provisions. This would decrease profit below
the trigger level for the bonus.
Analysis:
Ibrahim faces a self-interest threat which might distort his objectivity.
Ibrahim has a professional responsibility to ensure that financial information is prepared and
presented fairly, honestly and in accordance with relevant professional standards. He has further
obligations to ensure that financial information is prepared in accordance with applicable
accounting standards and that records maintained represent the facts accurately and completely
in all material respects.
Ibrahim must make the necessary adjustment even though it would lead to a loss to himself.

© Emile Woolf International 553 The Institute of Chartered Accountants of Pakistan

Advanced Accounting and Financial Reporting

© Emile Woolf International 554 The Institute of Chartered Accountants of Pakistan