FR - Accounting for transactions in financial

statements
Inventory and Biological Assets – IAS41

OBJECTIVE OF IAS 41:

The objective of IAS 41 is to establish rules for the accounting of agricultural activity. Agricultural activity refers to
the transformation of biological assets (living animals and plants) into agricultural produce (harvested product).

SCOPE OF IAS 41:

IAS 41 applies to:

- Biological assets (except bearer plants);

- Agricultural produce at the point of harvest; and
- Government grants related to biological assets.

IAS 41 does not apply to:

- Bearer plants;
- Land related to agricultural activity; and
- Intangible assets related to agricultural activity.

What are Bearer Plants?

A bearer plant is a living plant that:

A. Is used in the production or supply of agricultural produce;
B. Is expected to bear fruit for more than one period; and
C. Has a remote likelihood of being sold as agricultural produce, except for incidental scrap sales.

MEASUREMENT OF ASSETS:
The measurement rules are broken into biological assets and agricultural produce.

1. Biological Assets

Biological assets should be measured at fair value less estimated costs to sell, both at initial recognition as
well as upon subsequent measurement. The gain on initial recognition and subsequent changes in fair value
should be included in profit or loss. If the fair value cannot be measured reliably, the asset is measured at
cost less accumulated depreciation and impairment losses. Once the fair value becomes measurable, an
entity must switch to fair value treatment.

2. Agricultural Produce

Agricultural produce should be measured at fair value less estimated selling costs at the point of harvest.
The gain on initial recognition is taken to profit or loss. Since agricultural produce immediately becomes
inventory, there are no rules regarding subsequent measurement. Unlike biological assets, agricultural
produce must always be measured at fair value.

EXAMPLES:

- Sheep

Imagine a sheep that is kept to produce wool. The sheep is a biological asset and comes within the scope of
IAS 41. At the time of shearing, the wool is agricultural produce and again comes within the scope of IAS
41. Once sheared, the wool becomes part of inventory and is outside the scope of IAS 41.

In terms of measurement, the sheep, at the point of birth, is recognised at fair value less costs to sell. The
gain is taken to profit or loss. As the sheep grows, its fair value continues to change with corresponding
gains and losses being recognised in profit or loss. At the point of shearing, the fair value of wool is
measured and the gain is taken to profit or loss.

- Sugar Beet

Imagine sugar beet, a plant harvested in its entirety to extract sugar. The plant is a biological asset and
comes within the scope of IAS 41. At the time of harvesting, the beet is agricultural produce and again
comes within the scope of IAS 41. Once harvested, the beet becomes part of inventory and is outside the
scope of IAS 41.

GOVERNMENT GRANTS:

IAS 41 also applies to government grants. However, for that to be the case, corresponding biological assets
must be measured at fair value. If the biological assets are measured at cost less accumulated depreciation,
government grants should be treated as per IAS 20. Under IAS 41, unconditional grants should be reported as
income when they become receivable. Conditional grants should only be reported as income when all conditions
have been met.
 FR - Financial Reporting
Inventories (IAS 2) - Recognition and Measurement

SCOPE OF IAS 2:
IAS 2 applies to most items of inventory at various stages of the production process and those acquired with
various intentions, namely:

● Raw materials;

● Work-in-progress;

● Finished goods; and

● Goods acquired for resale.

Items explicitly excluded from the scope of IAS 2 are:

● Works-in-progress arising under construction contracts;

● Financial instruments;

● Biological assets related to agricultural activity and agricultural produce at the point of harvest;

● Inventories held by producers of agricultural and forest products, agricultural produce after harvest,
minerals and mineral products, to the extent that they are measured at net realisable value in
accordance with well-established industry practice; and

● Commodity broker-traders who typically measure their inventory at fair value less cost to sell.

DEFINITION OF INVENTORY:
Inventories include:

● Assets held for sale in the ordinary course of business, as would be the case for items of finished
goods or goods held for resale;

● Assets in the process of production for such sale, as in works-in-progress; and

● Assets in the form of materials or supplies to be consumed in the production process or in the
 rendering of services.

INITIAL RECOGNITION AND SUBSEQUENT REPORTING OF INVENTORY:

Items of inventory should be measured at the lower of cost and net realisable value. Initial recognition of
inventory is typically at cost, which includes:

● The purchase price of the actual inventory item, as adjusted for trade discounts and rebates
received;

● Transport costs;

● Import duties and other non-recoverable taxes, which for example would not include VAT, that is
value-added tax, which would typically be recovered; and

● Any other costs directly attributable to the inventories. These are:

○ Direct costs – direct material and labour

○ Variable production overheads – indirect material and labour

○ Fixed production overheads – maintenance and depreciation (allocation is performed

on the basis of normal capacity)

Costs specifically disallowed to be included in the measurement of inventory cost are:

● Abnormal amounts of wasted material, labour or other factors of production;

● Storage costs, unless those costs are a necessary part of the production process prior to a further
production stage;

● Administrative overheads which do not contribute to bringing inventories to their present location
and condition; and

● Selling costs.

In limited circumstances, where production extends over a long period of time and production volumes are small,
the cost of inventories will include borrowing costs as regulated by IAS 23.
 FR - Inventories (IAS 2) – Cost-flow
Assumptions
IAS 2 - Module 2

ASSUMPTIONS TO ESTABLISH THE COST OF HOMOGENEOUS ITEMS OF

INVENTORY:

In those cases, where inventory items are not interchangeable, in other words, they are heterogeneous, the cost
of each item should be established individually.

Where this is not the case (i.e. inventory is homogenous/interchangeable), it is necessary to apply simplifying
cost-flow assumptions and IAS 2 permits the use of:

- FIFO (first-in, first-out) assumption

- Weighted average cost (AVCO) formula

There is another practice around the globe called LIFO (last-in-first-out), where it is assumed that newest items
of inventory are sold first. However, this method is disallowed under IFRS.

In terms of choosing between FIFO and AVCO, IAS 2 states that the same cost formula should be used for all
inventories which have a similar nature and use to the company. It is, therefore, possible to apply the two
methods simultaneously to items with a different nature and use.

FIFO:

It is assumed that when inventories are sold or used in the production process, the oldest items are used first.
Consequently, the carrying amount of inventory at the end of a period reflects the cost associated with the most
recent purchases or batches of production.

AVCO:
Weighted average cost involves the computation of an average unit cost of the items on hand. This is done by
dividing the total cost of the items available by their number.
 FR - Financial Reporting
Accounting for Financial Instruments - Identifying Financial Assets and
Financial Liabilities

ACCOUNTING STANDARDS COVERING FINANCIAL INSTRUMENTS

The role of financial instruments in the global economy has been growing since the second half of the twentieth
century. At the same time, the complexity of financial products has been increasing at a rapid pace, due, in
particular, to the development of markets for financial derivatives.

The previous standards did not allow for the accurate recognition of financial products. In particular, they did not
facilitate the measurement of unrealised gains and losses which such instruments typically generate. Currently,
there are three main accounting standards devoted to financial instruments:

1) IAS 32 Financial Instruments: Presentation. This standard defines financial instruments and classifies
them as financial assets and financial liabilities. It also deals with the presentation of financial instruments in
financial statements.

2) IFRS 7 Financial Instruments: Disclosures. This standard prescribes the extent of information related to
financial instruments that companies are required to disclose in the notes to financial statements.

3) IFRS 9 Financial Instruments. This standard prescribes the classification of financial assets and financial
liabilities into categories and deals with the principles under which financial assets and financial liabilities
ought to be recognised and measured. Derecognition of financial instruments is also a topic covered in
IFRS 9.

Note: IFRS 13 Fair Value Measurement is another accounting standard which has a significant impact on how
financial instruments are accounted for. This standard contains a set of principles on how to estimate the fair
value of any asset or liability, including financial assets and financial liabilities.

IAS 32 states that a financial instrument is a contract, as a result of which one party recognises a financial
asset, while the other party recognises a financial liability or an equity instrument.

A financial asset is any asset that is:

● Cash;

● A contractual right to receive cash or another financial asset from another entity (e.g., trade
receivable);

● A contractual right to exchange financial assets or financial liabilities with another entity under
potentially favourable conditions (i.e., derivatives);
 ● An equity instrument of another entity (e.g., a share issued by another company which has been
purchased for investment purposes).

A financial liability is any liability that is a contractual obligation:

● To deliver cash or another financial asset to another entity (e.g., trade payable);

● To exchange financial assets or financial liabilities with another entity under potentially unfavourable
conditions (i.e., derivatives).

An equity instrument is any contract that evidences a residual interest in the assets of an entity after deducting
all of its liabilities. A typical equity instrument comes in the form of an ordinary or common share, whose owner,
the shareholder, has title to a pro-rata share of any assets which are left in the company after it settles all of its
liabilities.
 FR - Accounting for financial instruments
Financial Instruments - Module 2

CLASSIFICATION OF FINANCIAL ASSETS:

Key rule: All financial assets should be recognised in an entity’s statement of financial position at the moment
when the entity becomes a party to the financial instrument contract.

The value, at which a financial asset is measured upon initial recognition, is its fair value, which in some cases
requires adjusting by the amount of transaction costs that are directly attributable to the acquisition of the asset.
In most cases, when a financial asset is acquired in a transaction that is conducted on market terms, the
transaction price will be synonymous with the asset’s fair value upon initial recognition.

In accordance with IFRS 9, at initial recognition, a financial asset should be classified into an appropriate
category, which determines how that asset will be measured and presented in the financial statements in
subsequent periods. The standard requires financial assets to be classified into one of the following categories:

1) Financial assets measured at fair value through profit or loss. These assets are measured at fair value
in periods subsequent to their initial recognition, with gains and losses, amounting to the change in fair
value between reporting dates, recognised in the profit and loss account.
2) Financial assets measured at fair value through other comprehensive income. These assets are also
measured at fair value, but gains or losses arising from changes in their fair value from period to period are
not recognised within profit or loss, but in other comprehensive income instead.
3) Financial assets measured at amortised cost. These assets are amortised over their lifetime using the
effective interest rate method and adjusted for loss allowances, which reflect the credit risk of the
instrument’s issuer.

Note: The effective interest rate of a financial asset is a rate which discounts all of the estimated future payments
which that asset will generate, to its gross carrying amount, in other words, a carrying amount which does not
include any credit loss allowances. So, an effective interest rate may be thought of as the asset’s internal rate of
return.

Example:

A company purchases a share issued by another entity. The amount at which the share is initially recognised is
equal to its purchase price of 100 dollars. After one year, the fair value of the share is 120 dollars, and after two
years it changes to 108 dollars.

1) The share is classified as measured at fair value through profit or loss. If that was the case, after 1 year
from its purchase, the company would record a gain on the change in fair value amounting to 20 dollars,
which would be recognised in P&L. In year 2, the company would record a loss of 12 dollars representing
the drop in fair value from 120 to 108 dollars. This loss would be charged to P&L.
2) The share is measured at fair value through other comprehensive income. If that was the case, the gain of
20 dollars in the first year would be recorded within other comprehensive income, and so would the 12
dollar loss in the second year. Thus, the cumulative other comprehensive income attributable to the share
would amount to 8 dollars after two years from the share’s initial recognition.

Remember: if an equity instrument, such as a share, which is measured at fair value through other
comprehensive income is sold and derecognised from the company’s statement of financial position, the
cumulative gain or loss attributable to changes in its fair value would not be reclassified from other
comprehensive income and taken to profit or loss. However, if the financial asset measured at fair value through
other comprehensive income was a debt instrument, then its sale and derecognition would result in the
reclassification of the cumulative gain or loss on changes in fair value from other comprehensive income to profit
or loss.

The IFRS 9 principles for financial asset classification generally favour measurement at fair value through profit
or loss in the sense that classification of a financial asset to one of the other two categories is only possible if
two additional conditions are met simultaneously:

1) Business model criterion. This condition refers to the general business model, within which an entity
manages a specific portfolio of financial assets. The classification into the “measured at amortised cost” or
“measured at fair value through other comprehensive income” categories will only be possible if the
instrument in question is either managed within the so-called “held to collect” or “held-to-collect and for sale”
business models.
2) SPPI criterion. The asset may only generate cash flows representing solely payments of principal and
interest on the outstanding principal.

FINANCIAL ASSETS MEASURED AT AMORTISED COST:

Under IFRS 9, the financial assets measured at amortised cost category will only contain those debt
instruments, which are managed under the “held-to-collect” business model and which, simultaneously satisfy
the SPPI criterion.

Examples of financial assets that are typically classified as measured at amortised cost are:

- Loans granted to other entities, which a company will not sell before their maturity, but will wait and collect
the contractual cash flows, consisting only of principal and interest;
- Trade receivables, which the company does not intend to sell before their maturity are measured at
amortised cost.
FINANCIAL ASSETS MEASURED AT FAIR VALUE THROUGH OCI:

This category holds debt instruments, which also satisfy the SPPI criterion, but are managed under the “held to
collect and for sale” business model. These may, for example, be bonds, in which a company invests its cash
surplus, but does not necessarily intend to hold them until their maturity, but rather until that surplus may be
invested in a more profitable manner.

IFRS 9 also allows for equity instruments, but only those which are not held for trading purposes, to be classified
as financial assets measured at fair value through other comprehensive income. This is despite the fact, that
equity instruments, such as shares, do not generate interest payments and feature no principal repayment, and
will as such, by definition fail the SPPI test.

Note: The classification of equity instruments as financial assets measured at fair value through other
comprehensive income is performed on an instrument by instrument basis, and is irrevocable, which means that
preparers of financial statements will not be allowed to reclassify such instruments in subsequent periods.

FINANCIAL ASSETS MEASURED AT FAIR VALUE THROUGH PROFIT OR LOSS:

An entity will present all financial assets, which were not classified into the other two categories, to this category.
Accordingly, the category will comprise:

- Debt instruments, which do not satisfy the SPPI criterion, such as debt securities and granted loans, that
have an embedded derivative feature, such as an equity conversion or currency conversion option;
- All instruments managed under the “held for trading” business model, such as equity and debt securities
acquired for speculative purposes, as well as all financial assets resulting from derivative exposures;
- All equity instruments, which, upon their initial recognition, were not classified as measured at fair value
through other comprehensive income.

In addition to the above, IFRS 9 allows for the irrevocable designation of other financial assets to the measured
at fair value through profit or loss category, if such designation reduces a measurement inconsistency that would
otherwise arise.

Example:

Imagine a bank, whose source of funding is a deposit received from company A, amounting to $80 million. The
bank’s investments, presented under assets, comprise $10 million in cash, $20 million in bonds issued by the
United States Treasury, $40 million of residential mortgage loans granted to individual clients as well as $30
million in shares issued by company B. The difference between the investments and the funding source of 80
million is equal to the bank’s equity in the form of ordinary shares issued.

Statement of financial position

Assets Liabilities

Deposit (Company A) $80 million

Cash $10 million
Bonds (US Treasury) $20 million
Equity
Mortgage loans $40 million
Shares (Company B) $30 million
Shares issued $20 million

Knowing the basic principles which apply to the classification of financial assets, we may now discuss how these
financial assets could potentially be classified in the statement of financial position of the bank, and the reporting
consequences which this would generate:
1) Bonds (US Treasury). Let’s assume that the contractual cash flows generated by the bonds represent only
payments of principal and interest, so the bonds satisfy the SPPI criterion. Consequently, the correct
classification of the bonds will depend on the business model applied by the bank to these assets:
- “Held for trading” model. In this case, the bank’s economic purpose would be to profit from changes in
market prices and to realise gains by selling the bonds. Under this model, the bank would classify the bonds
as financial assets measured at fair value through profit or loss;
- “Held to collect and for sale” model. This approach reflects a situation, in which the investment serves the
purpose of profiting from the realisation of contractual cash flows, but also allows for the sale of the bonds if
needed. Under this model, the appropriate classification is measurement at fair value through other
comprehensive income;
- “Held to collect” model. This model results in the classification of the asset into the measured at amortised
cost category, without the need to report fair value. However, this business model would preclude the bank
from selling the securities before their maturity date. In practice, managing liquid debt instruments, which
are quoted in active markets, under the “held to collect” approach is possible, but rare.

2) Mortgage loans. Assuming that the SPPI criterion is satisfied, we should analyse the business model under
which the bank manages the loans:
- “Held to collect” model. Typically, banks hold issued loans to collect contractual cash flows, and in such
cases, the loans should be classified as financial assets measured at amortised cost. In this case, the loans
would not be measured at fair value but amortised using the effective interest rate method. Also, loss
allowances would need to be calculated and recognised to take account of the credit risk of borrowers.
Note: Business models other than “held to collect” are rarely encountered in practice in relation to granted
loans. Managing the loans under a different business model would result in a requirement to measure and
present their fair value at each reporting date.
Remember: Both the bonds and the loans would be classified as measured at fair value through profit or
loss if they failed to satisfy the SPPI criterion.

3) Shares issued by Company B. As you remember, the default classification in respect of equity instruments
is assets measured at fair value through profit or loss. The bank may, however, upon initial recognition,
irrevocably designate the shares to be measured at fair value through other comprehensive income, under
the condition that the shares are not held for trading purposes.

The chart below summarises the principles of classification and its accounting consequences:
 FR - Accounting for financial instruments
Financial Instruments - Module 3

CLASSIFICATION CRITERIA:

As you remember, the classification of financial assets, which take the form of debt instruments, to the measured
at amortised cost or the measured at fair value through other comprehensive income categories is only possible,
if two criteria are met:

1) Business model criterion;

2) SPPI criterion.

Note: The classification of a financial asset to any one of these categories is only possible if both criteria are met
simultaneously.

BUSINESS MODEL CRITERION:

The business model criterion is an assessment of how the entity manages its financial assets in order to
generate cash flows. IFRS 9 states that a company’s business model is a matter of fact rather than being an
abstract accounting concept, and is observed from how a company is actually managed.

The assessment of the business model is not based on a company’s intentions regarding an individual financial
asset but has to be determined at a higher level of aggregation, for example at the level of a portfolio of assets.

As you remember, the business model required for the classification of a financial asset to the measured at
amortised cost category, is the “held to collect” model (providing that they also pass the SPPI test), implying
that the company will only realise the contractual cash flows generated by assets managed within this model,
and will not sell those assets in order to, for example, realise a gain on temporary fluctuations in market values.

In opposition to the “held to collect” business model is the “held for trading” model, under which a company will
buy and sell financial assets in order to realise gains resulting from changes in market prices. Assets managed
within the “held for trading” business model, as well as other financial assets, which do not pass the SPPI test,
must be measured at fair value through profit or loss.
The third business model is “held to collect and for sale” model. When applying this approach, a company will
generally collect the contractual cash flows generated by the assets, but in certain circumstances, it will also sell
those assets, for example, to realise a gain from increases in market prices or to use the sales proceeds for the
purpose of making further investments. Debt instruments, which pass the SPPI test, and are managed under the
“held to collect and for sale” business model, as well as equity instruments managed within the same approach,
are classified as measured at fair value through other comprehensive income.

SPPI CRITERION:

The abbreviation SPPI stands for “solely payments of principal and interest” and in order to comply with this
criterion, a financial asset may not generate any cash flows other than payments of principal and interest on the
outstanding principal amount of the asset. Debt instruments, which do not contain additional features that would
add financial leverage to their contractual cash flows, typically meet the SPPI criterion.

According to IFRS 9, a debt instrument complies with the SPPI test, when its contractual cash flows are
consistent with a basic lending arrangement. In such arrangements, the most significant elements of the interest
which is charged by the lender, are the consideration for the time value of money and for credit risk. In other
words, the interest component in a basic lending arrangement typically consists of:

- The market rate of interest, which represents consideration for the time value of money;
- Margin, which provides compensation for the borrower’s or issuer’s credit risk.

Accordingly, if the cash flows generated by a debt instrument relate to components or factors other than the time
value of money and margin as applied to the outstanding principal of the instrument, then it is probable that such
an investment would not pass the SPPI test.

Example 1:

Imagine a bond, which has a defined maturity date and pays annual coupons at a fixed rate. The entire principal
of the bond, referred to as its nominal value, will be paid together with the final coupon. Furthermore, both the
coupons and principal are denominated in the same currency.

As we can see, the contractual cash flows generated by the bond comprise only fixed rate interest payments and
the principal amount. The cash flows from the bond are therefore clearly consistent with the basic lending
principle, and the instrument would be deemed SPPI-compliant.

Example 2:

Assume that the bond pays monthly coupons which are tied to a variable rate of interest, defined as 1-month
Euribor plus a margin of 50 basis points. The other features of the bond remain unchanged from the previous
example.

Although the bond’s coupon formula is now based on a variable rate, with an additional margin component, the
bond still meets the SPPI criterion. This is because the only cash flows generated by the bond are made up of:

- Interest tied to the Euribor index, which is clearly reflective of the time value of money;
- Margin, whose economic purpose is to cover the risks associated with the issuer, in particular, their level of
credit risk;
- Principal.
Adding even further weight to these arguments is the fact that both interest and principal are denominated in the
same currency and that the length of the interest period, one month, is consistent with the tenor of the market
interest rate, the one-month Euribor, chosen as the benchmark.

As it was already indicated, debt instruments, which do not meet the SPPI criterion, are typically those
instruments which carry additional features or options that increase the volatility of the instruments’ cash flows in
such a way that they are no longer consistent with the basic lending arrangement.

Certain embedded options and additional features will, however, not cause a violation of the SPPI criterion.
These are, first and foremost, the options to prepay the borrowing or to extend its term, as such options are
clearly still consistent with the basic lending arrangement.

Additionally, linking the interest charged on a debt instrument to an unleveraged inflation index will also not
constitute a violation of the SPPI criterion, providing the index relates to the same currency in which the bond is
denominated. Such a link ties the level of interest to a direct measure of the time value of money, hence
inflation-linked bonds will naturally be considered SPPI-compliant.

Examples of debt instruments, which fail to fulfil the SPPI criterion include:

1) Convertible bond. On the one hand, convertible bonds resemble ordinary debt instruments, which pay out
fixed or variable interest on the principal amount outstanding. On the other hand, they also feature an
option, which allows for the conversion of a bond’s nominal amount to a fixed number of shares in the
issuing entity. If the instrument is converted to equity, the cash flows generated by it will no longer be
reflective of the time value of money and the instrument will, therefore, no longer be consistent with a basic
lending arrangement;
2) A loan, whose interest is indexed to the debtor’s performance indicators (e.g., EBIT, EBITDA, Equity
price index). The cash flows generated from such a loan are clearly not consistent with a basic lending
arrangement, as they reflect the financial performance of the debtor, rather than the time value of money.

Remember: If a debt instrument satisfies the SPPI criterion, it may, when managed under the appropriate
business model, be classified to measurement at amortised cost or to fair value through other comprehensive
income. However, lack of SPPI compliance will always lead to measurement at fair value through profit or loss.
 FR - Financial Reporting
Accounting for Financial Instruments – Amortised Cost

FINANCIAL ASSETS MEASURED AT AMORTISED COST:

IAS 7 defines investing activities as the acquisition and disposal of long-term assets and other investments not
included in cash and cash equivalents (e.g., the purchase or sale of a long-term bond).

As you remember, the only type of financial asset which may be measured at amortised cost, is debt
instruments, such as purchased bonds, trade receivables, or loans granted to other entities.

In order to be measured at amortised cost, a debt instrument has to be managed within a business model, under
which the company will only realise the instrument’s contractual cash flows - the so called “held to collect”
business model. Additionally, the instrument must also comply with the SPPI criterion, meaning that its
contractual cash flows may only include payments of principal and interest.

IFRS 9 defines amortised cost as follows:

= Initial recognition

－ Repayments of principal

+(-) The cumulative amortisation, using the effective interest method

+(-) Further adjustment for loss allowances

= Amortised cost

The cumulative amortisation is the difference between the initial amount and the maturity amount.

The effective interest rate is the rate which exactly discounts all of the cash flows which are expected
throughout the life of the asset to its gross carrying amount - that is a book value, which has not been adjusted
downward for loss allowances.

At each reporting date, between the asset’s initial recognition and its maturity, the carrying amount of that asset,
as measured under the amortised cost approach, will be adjusted for the following items:

a) Interest income for the period, calculated by applying the instrument’s effective interest rate to the asset’s
beginning-of-period carrying value.
b) Any contractual cash flows that were generated by the asset over the course of the period.

An asset can be classified as measured at fair value through other comprehensive income if it is managed
within a “held to collect and for sale” business model and complies with the SPPI criterion. The applicable
financial reporting requirements are very similar to those related to financial assets measured at amortised cost:

● Upon initial recognition, the asset will also be measured at its fair value adjusted for transaction costs
directly attributable to its purchase.

● The holder will need to compute the instrument’s effective rate of interest and measure the asset’s
amortised cost at each reporting date. This is necessary, as the holder will report interest income, which will
be recognised in profit or loss, by applying the effective interest rate to the asset’s amortised cost.

● The difference between the asset’s amortised cost and its fair value as measured at the reporting date will
be presented as a gain or loss within other comprehensive income. This is the main difference compared to
how debt instruments are accounted for under the pure amortised cost approach.
 FR - Financial Reporting
Accounting for Financial Instruments – Financial Liabilities

FINANCIAL LIABILITIES
A financial liability represents an obligation to deliver cash or another financial asset to another entity; or to
exchange financial assets or liabilities with another entity on potentially unfavourable terms. At initial recognition,
a financial liability is measured at fair value, which is typically equal to the net proceeds received for assuming
the underlying obligation.

Financial liabilities must be classified into one of two categories:

1) Financial liabilities measured at fair value through profit or loss. This category comprises mainly
liabilities resulting from derivative exposures, as well as financial liabilities which are held for trading, such
as short positions in securities.

2) Financial liabilities measured at amortised cost. This category includes types of financial liabilities such
as issued bonds and loans or trade payables. The main difference compared to financial assets is that in
the case of financial liabilities, we recognise an interest expense instead of interest income.

The interest expense is computed using the effective interest rate of the liability, which is defined as the rate that
discounts all contractual cash flows generated by the instrument to its carrying amount, taking into account
transaction costs incurred upon issuance, and reflecting any discounts or premiums at which the liability was
issued as compared to its nominal value.

The amortised cost of a financial liability at the end of a period is calculated as follows:

Amortised cost = Amortised cost at the beginning of the period + Interest expense - Payments made

Note: The amount of interest expense is calculated using the instrument’s effective interest rate.

Some of the financial instruments issued by companies contain features of both financial liabilities and equity
instruments. However, a critical distinction exists when it comes to the nature of the cash flows which they
generate for the benefit of their holders. While the distribution of dividends to holders of equity instruments is
subject to conditions such as achieving a particular level of company earnings, interest on debt is payable
independently of the issuer’s financial performance.

There may be instruments which assume the legal form of equity, but at the same time contain an obligation to
make cash distributions, which resemble the interest paid in respect of debt. An example of such an instrument
is a preference share, which on one hand is an equity instrument in the sense that it represents a claim on the
residual assets of the issuing company, and on the other, it generates a guaranteed return – a level dividend,
which resembles the coupon or interest paid on a bond.
In order to determine the classification of such instruments, we need to look at the remaining features of such
shares. Typically, if the preference shares are redeemable, then they will be classified as liabilities of the issuer,
and if not, then they ought to be treated as equity instruments.

Note: If the preference share is classified as equity then its dividends are also reported as a direct charge
against equity. On the other hand, if the share is presented within liabilities, then the dividends which it pays out
are recognised as an expense within profit or loss. Remember that the classification of an instrument as equity
or liability does not depend on its legal form, but on the economic substance created by the instrument’s
contractual provisions.

Compound financial liabilities are instruments which consist of at least two components with different
economic characteristics.

An example of such an instrument is a convertible bond, that is a debt instrument, which may be converted into
the issuer’s shares upon maturity. In other words, at the redemption date, the holders of such bonds may choose
to either have their bonds redeemed for their nominal or principal value; or may opt to receive shares instead,
where the number of those shares is specified upfront in the bond prospectus.

Accounting for convertible instruments follows an approach commonly referred to as split accounting, which
means that the entity will recognise, separately, the instrument’s liability component, based on the present value
of its contractual cash flows and assuming that it is not converted. The difference between the fair value of the
entire instrument at its inception and the computed carrying amount of the liability is naturally then allocated to
the instrument’s equity component.

Remember: In those cases where the compound financial liability contains an embedded financial instrument
that would otherwise be classified as measured at fair value through profit or loss, the entity may choose
between using split accounting, or irrevocably, designate the entire compound financial liability to be measured
at fair value through profit or loss without the need to artificially break the instrument down into its component
parts.
 FR - Financial Reporting
Accounting for Financial Instruments – Derecognition of Financial Assets
and Financial Liabilities

DERECOGNITION OF FINANCIAL INSTRUMENTS

Financial liabilities are removed from the statement of financial position when, and only when, they are
extinguished; where extinguishment is defined as the discharge, cancellation, or expiration of the liability. A
typical circumstance, in which a financial liability is derecognised, is its repayment at maturity.

In some circumstances, the derecognition of a financial liability may also trigger the simultaneous recognition of
a gain or loss. This will be the case when there is a difference between the carrying amount of the financial
liability being derecognised and the consideration paid to discharge it. However, in most cases, the amount paid
to extinguish a financial liability will be equal to its carrying amount.

A financial asset ought to be derecognised from an entity’s statement of financial position when the contractual
rights to the cash flows from that asset have expired, or when the entity has transferred the asset and the
transfer qualifies for derecognition.

In accordance with IFRS 9, a financial asset is transferred either:

a) When its holder has transferred to another entity the contractual rights to receive cash flows from the asset;
or

b) When the holder has retained those contractual rights but has assumed an obligation to pass the cash flows
from the asset on to another entity.

Note: In order to be considered a genuine transfer, the terms of the obligation to pass on the cash flows
coming from the financial asset must simultaneously prohibit the transferor from selling or pledging the
asset to a third party. Also, the transferor must be obliged to pass on only the amounts which have actually
been received from the asset, irrespective of whether those amounts reflect the contractual terms of the
instrument. Additionally, to qualify as a transfer, the remittance of cash flows should occur without delay.

The conditions under which such transfers will qualify for derecognition relate to an assessment of whether the
transaction results in the transfer of substantially all of the risks and rewards of ownership of the financial asset
(i.e., all financial risks inherent to the underlying asset, such as credit risk, price risk, interest rate and currency
risk, to which the holder of the asset has a material exposure). Such an analysis is performed by comparing the
company’s exposure to changes in the cash flows and value of the financial asset before and after the
transaction.

From the point of analysing the transfer of risk, we must consider the two broad categories of factoring
agreements:
1) Factoring with recourse: Here, the factor is entitled to return to the company those receivables which were
not repaid by their debtors or, alternatively, to claim a reimbursement for amounts not collected. Under
factoring with recourse, substantially all of the risks associated with ownership of the receivables which are
subject to the agreement, are retained by the company, with the effect that those receivables must remain in
the company’s statement of financial position.

2) Factoring without recourse: Under this agreement, the factor is not entitled to any refunds in respect of
amounts not collected. Therefore, the credit risk is considered to have been effectively transferred from the
company to the factor. As a result, the receivables are derecognised from the company’s statement of
financial position.

Derecognition of a financial asset is accounted for in a similar way to an outright disposal. The asset is removed
from the statement of financial position, and the consideration received is obviously recognised within cash, with
any difference being treated as a gain or loss on disposal.

If the transaction does not trigger derecognition, as is the case with factoring with recourse, any consideration
received must be accounted for by recognising a corresponding liability, which reflects the company’s obligation
to reimburse the factor for any receivables where collection efforts prove unsuccessful.
 FR – Accounting for transactions in financial
statements
Leases - IFRS 16 - Part 1

DEFINITION OF LEASE:

A contract, or part of a contract, that conveys the right to use an asset, referred to as the
Lease:
underlying asset, for a period of time in exchange for a consideration.

Lessee: The entity which obtains the right to use the underlying asset.

Lessor: The provider of that right to use the underlying asset to lessee.

NOTE:
What is crucial to understand is that throughout the period covered by the lease agreement, the lessor remains
the legal owner of the underlying asset. On the other hand, the lessee has possession of the asset and the
right to make use of it but does not have legal title to it.

You should also appreciate that under IFRS, the term ‘lease’ is to be understood quite broadly. It applies to all
agreements which meet the above definition. After all, an agreement to hire or rent an asset, such as office
space, satisfies the IFRS 16 definition of a lease even if it is not explicitly called a lease agreement.

RECOGNITION OF LEASE AT INCEPTION BY LESSEE:

The standard requires that at inception of the lease, the lessee recognises both:
1. A lease liability:
The lease liability is initially measured at the present value of the following lease payments during the lease
term that have not been paid at the commencement date:

● Any fixed or variable payment, in the case of variable payments, their size will typically depend on the
level of a rate or index (such as LIBOR). If that is the case, for the purposes of measuring the present
value of variable payments over the lease term, we assume that the relevant rate or index will remain
unchanged from the level observed at the commencement date.
● Any amounts expected to be payable by the lessee under residual value guarantees, that is
obligations of the lessee to make the lessor good for any shortfalls of the underlying asset’s market value
below a specified amount.
● The exercise price of any purchase options which the lessee is reasonably certain to exercise.
● Any termination penalties, if the lease term reflects the lessee exercising an option to terminate the
contract early.

Discount factor:
The requirement to compute a present value naturally involves the need to identify an appropriate discount
rate. This is defined as the interest rate implicit in the lease, which is an effective rate of return as
computed by the lessor, reflecting:

● The underlying asset’s initial fair value;

● The lessor’s direct costs of arranging the contract;
● Payments expected to be received by the lessor;
● The asset’s expected residual value.

As the interest rate implicit in the lease is clearly defined from a lessor perspective, it may not readily be
determinable by the lessee. If that is the case, the lessee should discount the lease payments using its own
incremental borrowing rate, which is the rate at which it could borrow funds to purchase the underlying asset
outright.

Lease term:
Let us also note that computing the lease liability requires identifying payments which will occur over the
lease term. So, what do we actually mean by the lease term? IFRS 16 defines it as the non-cancellable
period of the lease, together with both:

● Periods covered by an option to extend the lease if the lessee is reasonably certain to exercise such an
option,
● Periods covered by an option to terminate the lease if the lessee is reasonably certain not to exercise
that option.
2. A right-of-use asset:
This is an asset which reflects the lessee’s right to use the underlying asset over the lease term, IFRS 16
states that the asset should initially be measured at cost, which comprises:

● An amount equal to the initial value of the lease liability, computed as described just a moment ago; plus
● Any lease payments made at or before the commencement of the contract; plus
● Any initial direct costs incurred by the lessee; plus
● An estimate of the costs to be incurred by the lessee in association with 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.

Example:
With these definitions and rules in place, let’s consider the following example:

A company enters into a two-year non-cancellable agreement to lease an item of property, plant and equipment,
which requires it to make two payments of €402 in arrears, which is at the end of each year. The agreement
contains an option to extend the lease for an additional, third year, under the same terms as during the non-
cancellable period. The company is reasonably certain that it will exercise this option. The company incurs initial
direct legal costs of €200 in association with signing the contract. The underlying asset has a useful life of six
years with no residual value. The interest rate implicit in the lease is not readily determinable by the lessee. Its
incremental borrowing rate equals 10%.

Identify the lease term:

Let us start by identifying the lease term, although the contract is signed for a period of 2 years, the fact that the
lessee is reasonably certain to exercise the option to extend it for another year, leads us to conclude that the
lease term is in fact 3 years.

Initial carrying amount of the lease liability:

Let us now move on to calculate the initial carrying amount of the lease liability, which is equal to the present
value of the lease payments to be made over that 3 year lease term, calculated as follows:

Year Outflow (€) Discount factor Calculation Present value (€)

1 402 1.1 402 ÷ 1.1 366

2 402 1.12 402 ÷ 1.12 332

3 402 1.13 402 ÷ 1.13 302

Total 1,206 1,000

Initial carrying amount of the right-of-use asset:
If we now shift our attention to the right-of-use asset, we find that its initial carrying amount consists of the
€1,000 computed in respect of the lease liability and the €200 incurred in respect of incremental legal costs, to
produce an overall amount of (€1,000 + €200 =) €1,200.

Recording transaction:
The entries necessary to record the lease contract at its inception are therefore as follows:

Debit ➔ Right-of-use asset ➔ €1,200

Credit ➔ Cash ➔ €200

Credit ➔ Lease liability ➔ €1,000

EXEMPTIONS FROM THE REQUIREMENT TO RECOGNISE LEASE:

It must be mentioned that IFRS 16 contains two important exemptions from the requirement to recognise all
lease contracts. These relate to:

● Short-term leases:
A short-term lease is one, which has a term of 12 months or less, at the commencement date. It must,
however, be stressed that a lease which contains an option to purchase the underlying asset may not be
considered a short-term one.

IFRS 16 states that the short-term exemption may be made by class of underlying asset, which is a grouping
of assets with a similar nature and use. Once the lessee establishes a policy for a specific class of assets, all
future short-term leases which relate to that class must be accounted for in accordance with the policy
adopted.

● Those contracts where the underlying asset is of low value:

The second exemption pertains to leases of low value assets. This time, however, the decision on whether
to make use of the exemption or not can be made on a lease-by-lease basis.

The assessment of whether an underlying asset is indeed of low value is based on the value of the asset
when it is new, regardless of the age of the asset actually being leased. What is more, the evaluation should
not be affected by the size, nature or circumstances of the lessee.

NOTE: IFRS 16 does not provide any monetary threshold for what constitutes low value. It does, however,
list the following examples of low-value assets: desktop and laptop computers, small items of furniture, or
telephones.

If the lessee chooses to utilise one of the two exemptions described above, they do not recognise a lease liability
or right-of-use asset at all. Instead, the lessee recognises the lease payments which it is obliged to make either
on a straight-line basis over the lease term or some other systematic basis which would be more reflective of the
pattern of benefits generated by use of the asset.

Example:
Imagine a company which has just signed a three-year agreement to lease a laptop. The underlying asset is
deemed to be of low value and the company has elected to apply the recognition exemption for this category of
items. The contract specifies that monthly rentals of €60 will be payable but as a form of incentive, use of the
laptop is granted rent-free for the initial six months.

Compute total lease payments:

In this case, we first need to compute the overall lease payments which the lessee will make across the entire 3
year period, and that’s 30 lots of €60, or (30 x €60 =) €1,800.

Allocate total lease payments to lease term:

This amount will then need to be allocated to each of the 36 months of the lease term using a straight-line
approach, producing an effective charge of (€1,800 ÷ 36 =) €50 per month.

Recording transaction:
Given the fact that over the initial six months of the agreement, the lessee suffers no cash outflows, this will be
recorded as a monthly €50 debit to expenses within P&L and a corresponding credit to accruals within liabilities:

Debit ➔ Rental expense ➔ €50

Credit ➔ Accrual (liability) ➔ €50

At the end of the rent-free period, the balance of the accruals account should, therefore, equal six lots of €50, or
€300:

Debit ➔ Rental expense ➔ €50 x 6 months = €300

Credit ➔ Accrual (liability) ➔ €50 x 6 months = €300

Over the following two and a half years, or 30 months, this balance will be amortised away so as to reconcile the
difference between the monthly cash outflow suffered and the amount of rental expense recognised in profit or
loss, the appropriate monthly accounting entries being:

Debit ➔ Rental expense ➔ €50

Debit ➔ Accrual (liability) ➔ €10

Credit ➔ Cash ➔ €60

It should be clear that as a result of this treatment, by the end of the lease term, the balance of the accrual
liability ought to be reduced to zero:

Debit ➔ Rental expense ➔ €50 x 30 = €1,500

Debit ➔ Accrual (liability) ➔ €10 x 30 = €300

Credit ➔ Cash ➔ €60 x 30 = €1,800

The €300 rental expense recorded in first 6 months of the lease term makes the total rental expense charged in
profit or loss equal to (€1,500 + €300 =) €1,800.
 FR – Accounting for transactions in financial
statements
Leases - IFRS 16 - Part 2

SUBSEQUENT MEASUREMENT OF RIGHT-OF-USE ASSET:

IFRS 16 requires that the right-of-use asset be measured using a cost model, unless the lessee elects a different
approach, such as the revaluation model described in IAS 16 and IAS 38 or the fair value model allowed under
IAS 40.

Applying the cost model implies measuring the asset at its initial cost:
● Less: accumulated depreciation, and
● Less: any accumulated impairment losses.

Depreciation of 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
lessee is reasonably certain to exercise a purchase option, the right-of-use asset is depreciated from the
commencement date to the end of the useful life of the underlying asset. Otherwise, the right-of-use asset ought
to be depreciated over the shorter of the asset’s useful life and the lease term.

SUBSEQUENT MEASUREMENT OF LEASE LIABILITY:

The carrying amount of the liability is computed by taking its opening balance, adding an interest charge
calculated in respect of the period, which is also recognised as an expense in the lessee’s profit or loss account,
and deducting the amount of payment actually made.

Periodic interest rate:

The periodic rate of interest which ought to be used is the discount rate applied to measure the initial carrying
amount of the liability at commencement of the contract. The amount of interest expense recognised is the result
of multiplying the discount rate by the lease liability balance outstanding at the beginning of the relevant period.

EXAMPLE (LEASE PAYMENTS IN ARREARS):

A company enters into a two-year non-cancellable agreement to lease an item of property, plant and equipment,
which requires it to make two payments of €402 in arrears. The agreement contains an option to extend the
lease for an additional, third year, under the same terms as during the non-cancellable period. The company is
reasonably certain that it will exercise this option. The company incurs initial direct legal costs of €200 in
association with signing the contract. The underlying asset has a useful life of six years with no residual value.
The interest rate implicit in the lease is not readily determinable by the lessee. Its incremental borrowing rate
equals 10%.

Initial recognition of right-of-use-asset and lease liability:

The relevant lease-term in this case is 3 years, we can also compute the initial carrying amount of right-of-use
asset and lease liability to be €1,200 and €1,000 (refer to ‘Leases - key terms & initial measurement’ for details).

Subsequent measurement of right-of-use asset:

Let us consider the subsequent measurement of the right-of-use asset. We will assume that the company
follows the straight-line method to provide for its depreciation. As there is no mention of the lease agreement
transferring ownership of the underlying asset, nor does it feature a purchase option, the relevant depreciation
period equals 3 years (the lease term).

Accordingly, over the course of the first year, as well as the subsequent two years, depreciation of the right-of-
use asset produces an annual charge of (€1,200/3 =) €400:

Opening right-to-use Depreciation charge Closing right-to-use

Year
asset value (€) (€) asset value (€)
1 1,200 (400) 800

2 800 (400) 400

3 400 (400) -

This is naturally recorded as:

DR: Depreciation expense (P/L)

CR: Right-of-use asset account
Subsequent measurement of lease liability:
Let us now deal with the evolution of the lease liability, which as we already stated, grows by an amount equal to
the interest charge calculated in respect of each period and falls to reflect payments made. We are easily
capable of computing the overall interest expense contained in the lease agreement. This is equal to the
difference between the sum of the lease payments, that is the three lots of €402 which give a total of €1,206,
and the initial carrying amount of the lease liability recorded in the statement of financial position. The difference,
(€1,206 – €1,000 =) €206 is the overall interest charge which the lessee will recognise over the duration of the
lease agreement. The trick lies in apportioning this total to specific periods.

As we have already stated, IFRS 16 requires that the interest expense recognised in a given period be
computed by applying the discount rate identified at lease inception (10%) to the outstanding balance of the
lease liability.

So, in the first year, the interest charge is calculated by taking the initial carrying amount of €1,000 and
multiplying it by 10% to produce a charge of €100, which is accounted for by:

DR: Finance costs (P/L) ➔ €100

CR: Lease liability ➔ €100

Thus increasing its carrying amount to €1,100, the liability is subsequently reduced by the amount of the cash
payment made at the end of the year:

DR: Lease liability ➔ €402

CR: Cash ➔ €402

Accordingly, by the end of the first year, the balance of the lease liability drops to (€1,100 – €402 =) €698. This
can be presented as:

A B C D=A+B–C

Year Opening balance € Interest charge € Payment made € Closing balance €

1 1,000 100 (402) 698

In year 2, the lessee follows a similar procedure. The closing balance from year 1 is transferred as the opening
balance for the second year. The 10% discount rate is, once again, applied to the outstanding balance of the
lease liability, this time producing an increase and corresponding finance expense of (€698 x 10% =) €70. This is
subsequently decreased by the payment made, bringing the closing balance to a level of (€698 + €70 – €402 =)
€366. This can be presented as:
 A B C D=A+B–C

Year Opening balance € Interest charge € Payment made € Closing balance €

1 1,000 100 (402) 698

2 698 70 (402) 366

In year 3, applying 10% to the opening balance of €366 produces a final interest charge of (€366 x 10% =) €36.
When the last cash payment is made, the balance of the liability falls to zero, effectively showing that the lessee
has no further obligation towards the lessor. Looking at the table, let’s quickly sum up the entries made in the
interest charge column, recalling that each year, these numbers were recorded as a debit to finance costs in
profit or loss and a credit to the lease liability account. When we add the numbers (that’s €100 for year 1, €70
from year 2 and €36 from the final year) we arrive at a total of €206, which we previously identified as the overall
interest cost of the lease:

A B C D=A+B–C

Year Opening balance € Interest charge € Payment made € Closing balance €

1 1,000 100 (402) 698

2 698 70 (402) 366

3 366 36 (402) -

Total 206

Current and non-current liability element:

Let us also examine, the treatment of the year-end lease liability balance from the perspective of splitting it into a
current and non-current element.

At the end of the first year, the overall balance of the lease liability is €698 and comprises principal only, seeing
as the entire interest or charge which accrued over the course of the first year, has already been settled. Some
of this €698 balance will be repaid over the course of the second year, whereas the remainder will be paid off in
year 3. It is in fact easier to start with the latter portion, as this is effectively equal to the balance of the lease
liability one year later, which is at the end of year 2.

So, out of the €698 lease liability balance outstanding at the end of year 1, €366 is payable beyond one year,
making it a non-current liability, whereas the rest, so (€698 – €366 =) €332 is up for repayment over the course
of the next 12 months, within year 2, making this portion of the liability, current.

Naturally, performing a similar split at the close of the second year would not really make sense, as the entire
€366 liability balance is repayable over the course of the upcoming year, making the liability current in its
entirety.
So, in summary the following will be the break-up of current and non-current liability for the lease liability:

Total carrying amount Current liability portion Non-current liability

Year
of lease liability (€) (€) portion (€)
1 698 698 – 366 = 332 366

2 366 366 – 0 = 366 -

EXAMPLE (LEASE PAYMENTS IN ADVANCE):

Let us now explore an alternative scenario, in which payments are made in advance as opposed to in arrears.

Once again, let us assume that a company enters into a two-year non-cancellable agreement to lease an item of
property, plant and equipment. This time, however, the agreement will call for two payments of €365.5 due at the
beginning of each year, with the first payment taking place at inception of the contract. As before, the agreement
contains an option to extend the lease for an additional, third year, under the same terms as during the non-
cancellable period. The company is reasonably certain that it will exercise this option. The company incurs initial
direct legal costs of €200 in association with signing the contract. The underlying asset has a useful life of six
years with no residual value. The interest rate implicit in the lease is not readily determinable by the lessee. Its
incremental borrowing rate equals 10%.

Initial recognition of right-of-use-asset and lease liability:

The relevant lease-term, in this case is 3 years, as the first installment is paid at the start of year 1(inception of
lease agreement), the initial carrying amount of the lease liability is therefore calculated as the present value of
the remaining lease payments, which are scheduled to take place at the start of year 2 and year 3:

Y A B C = A÷ B
Year Outflow Discount factor @ 10% Present value
(Beginning) (€) (€) (€)
2 365.5 1.1 332.3

3 365.5 1.12 302.1

Total 634.5 (approx.)

Next, we will move on to the initial carrying amount of right-of-use asset, this will comprise of:

● An amount equal to the initial value of the lease liability, so that’s the €634.5 just computed, plus
● Any lease payments made at or before the commencement of the contract, and that is the initial €365.5
already paid, plus
● The initial direct costs incurred by the lessee, which gives another €200.
The total right-of-use asset is (€634.5 + €365.5 + €200 =) €1,200. The double entries used to record this asset
will be:

DR: Right-of-use asset account ➔ €1,200

CR: Lease liability ➔ €634.5

CR: Cash (first instalment) ➔ €365.5

CR: Cash (initial direct costs) ➔ €200

Subsequent measurement of right-of-use asset:

Just as before, we may assume that the right-of-use asset will be depreciated over the three year lease term
using the straight-line method, producing a level charge of €400 per year. This can be depicted as:

Opening right-to-use Depreciation charge Closing right-to-use

Year
asset value (€) (€) asset value (€)
1 1,200 (400) 800

2 800 (400) 400

3 400 (400) -

Subsequent measurement of lease liability:

Let us now cross over to the lease liability. For the first year, we start off with an opening balance of €634.5, on
which an interest expense of €63.5 is computed by applying a rate of 10%. At year-end, the interest charge
remains outstanding, so the closing balance of the lease liability comes in at €698, and this naturally gets carried
over as the opening balance for year 2:

Y A B C=A–B D = C x 10% E=C+D

Interest
Opening Payment made Adjusted Closing
Year change
balance (€) (€) balance (€) balance (€)
(€)
1 634.5 - 634.5 63.5 698

Starting with the second year, however, the lease liability table requires additional columns. Because the
payments take place at the beginning of the period, the second column is called ‘payment made’, and that’s
€365.5, followed by an ‘adjusted balance’ column to show the amount of lease liability still outstanding after that
beginning-of-year payment. So, in year 2, the adjusted balance equals €332.5, which provides us with the basis
for computing the interest charge for the year. Just as we did before, we arrive at the charge by applying the
10% rate of interest to the lease liability outstanding throughout the year, and that’s the adjusted balance, which
yields a result of €33. The closing balance as at the end of year 2 is therefore 365.5:
Y A B C=A–B D = C x 10% E=C+D
Opening Payment made Adjusted Interest change Closing
Year
balance (€) (€) balance (€) (€) balance (€)
1 634.5 - 634.5 63.5 698

2 698 (365.5) 332.5 33 365.5

This is obviously carried forward as the opening balance for the third year and gets paid off right at the start of
the period, bringing the adjusted balance to zero. Please note that this gives no room for any interest expense to
be computed in respect of year 3. After all, a charge may only be calculated if there is a liability outstanding,
which is no longer the case:

Y A B C=A–B D = C x 10% E=C+D

Opening Payment made Adjusted Interest change Closing
Year
balance (€) (€) balance (€) (€) balance (€)
1 634.5 - 634.5 63.5 698

2 698 (365.5) 332.5 33 365.5

3 365.5 (365.5) - - -

Current and non-current liability element:

We should note that when payments are made in advance, the split into the non-current and current portion of
the lease liability involves identifying the balance which will be outstanding after the next payment is made, as
this effectively constitutes the non-current liability.

For example, of the overall €698 lease liability outstanding as at the end of year 1, the non-current portion would
equal €332.5 (the adjusted balance following the next payment). The current element would therefore be
computed as the difference between the total liability and its non-current portion, producing a result of €365.5,
which naturally corresponds to the size of the upcoming payment. This can be summarised as follows:

Total carrying amount Current liability portion Non-current liability

Year
of lease liability (€) (€) portion (€)
1 698 689 – 332.5 = 365.5 332.5

2 365.5 365.5 – 0 = 365.5 -

 FR – Accounting for transactions in financial
statements
Leases - IFRS 16 - Part 3

SALE AND LEASEBACK AGREEMENT:

Under a sale and leaseback agreement, the original owner of an asset, typically an item of property, transfers
that asset to another party, and simultaneously leases the asset back, so as to retain the right to use it in the
same manner as before.

Therefore, for the purpose of sale and leaseback transaction, we will be referring to the asset’s original owner
interchangeably as the seller or the lessee. On the other hand, the buyer will also be referred to as the lessor.

NOTE: This transaction generates an immediate cash flow. And it is precisely this cash injection which provides
the most frequent motivation for the seller, whose non-current asset portfolio may constitute an otherwise
untapped source of much-needed liquidity.

Accounting for sale and leaseback transaction:

The key to properly accounting for sale and leaseback transactions is to determine whether the transfer of the
asset qualifies as a sale in accordance with the rules laid out in IFRS 15 – Revenue from contracts with
customers.

IFRS 15 – brief recall:

Let us briefly recall IFRS 15, IFRS 15 requires that for a sale to be recognised, control must be transferred from
the seller, in our case, that’s the lessee, to the buyer (lessor). The standard goes on to list the following
indicators of the transfer of control:
● The seller has a present right to payment for the asset,
● The buyer has legal title to the asset,
● The seller has transferred physical possession of the asset,
● The buyer has the significant risks and rewards of ownership of the asset,
● The buyer has accepted the asset.

NOTE:
● None of these indicators may be considered as individually decisive in determining whether the seller-lessee
has indeed transferred control over the underlying asset to the buyer-lessor.
● What is more, not all of the indicators need to be present to establish that control has indeed been passed
over.

If sale and leaseback transaction does not qualify as a sale:

If it is determined that the transfer does not qualify as a genuine sale under IFRS 15, then the seller (lessee)
continues to recognise the transferred asset and simultaneously recognises a financial liability corresponding
to the transfer proceeds. This implies that the transfer proceeds are, in substance, a loan, which is subsequently
measured under IFRS 9.

If sale and leaseback transaction qualifies as a sale:

On the other hand, if the transfer satisfies the requirements of IFRS 15 to be accounted for as a genuine sale,
then the seller (lessee):

● Measures the right-of-use asset that results from the leaseback at the proportion of the underlying asset’s
carrying amount that relates to the rights which have been retained;
● Recognises a gain or loss only in proportion to the rights which have been transferred to the buyer (lessor).

EXAMPLE:

Let us now clarify these concepts with the aid of a simple example. Consider a company which owns an item of
property, plant and equipment with a book value of €7.2 million and a remaining useful life of 12 years. The
asset is sold to a financial institution for its current fair value of €10 million and is simultaneously leased back in
return for three annual payments of €2.3 million to be made in arrears.

The transaction qualifies as a sale under IFRS 15. The present value of the payments which the seller-lessee is
required to make over the lease term equals €5.7 million. This has been computed using a 10% rate implicit in
the lease, which is readily determinable by the lessee.

Carrying amount of right-of-use-asset:

Let us begin by calculating the carrying amount of the right-of-use asset arising from the leaseback at the
proportion of the previous carrying amount of the underlying asset that relates to the rights retained. This is
calculated as:

𝑃𝑟𝑒𝑠𝑒𝑛𝑡 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑙𝑒𝑎𝑠𝑒 𝑝𝑎𝑦𝑚𝑒𝑛𝑡𝑠

× 𝐶𝑎𝑟𝑟𝑦𝑖𝑛𝑔 𝑎𝑚𝑜𝑢𝑛𝑡 𝑜𝑓 𝑡ℎ𝑒 𝑎𝑠𝑠𝑒𝑡
𝑈𝑛𝑑𝑒𝑟𝑙𝑦𝑖𝑛𝑔 𝑎𝑠𝑠𝑒𝑡 ′ 𝑠 𝑓𝑎𝑖𝑟 𝑣𝑎𝑙𝑢𝑒

€5.7 𝑚𝑖𝑙𝑙𝑖𝑜𝑛
× €7.2 𝑚𝑖𝑙𝑙𝑖𝑜𝑛 = 57% × €7.2 𝑚𝑖𝑙𝑙𝑖𝑜𝑛 =× €4.1 𝑚𝑖𝑙𝑙𝑖𝑜𝑛
€10 𝑚𝑖𝑙𝑙𝑖𝑜𝑛

NOTE: We should emphasise that the computed 57% reflects the proportion of the rights retained by the
lessee.

Gain/loss recognised by seller/lessee:

At the same time, the lessee recognises a gain in proportion to the rights which have been transferred to the
buyer (lessor). The gain on the sale of the asset amounts to:

(𝑆𝑎𝑙𝑒𝑠 𝑝𝑟𝑜𝑐𝑒𝑒𝑑𝑠 − 𝐶𝑎𝑟𝑟𝑦𝑖𝑛𝑔 𝑎𝑚𝑜𝑢𝑛𝑡 𝑜𝑓 𝑡ℎ𝑒 𝑎𝑠𝑠𝑒𝑡) × (100% − 𝑅𝑖𝑔ℎ𝑡𝑠 𝑟𝑒𝑡𝑎𝑖𝑛𝑒𝑑 𝑏𝑦 𝑙𝑒𝑠𝑠𝑒𝑒)

(€10 𝑚𝑖𝑙𝑙𝑖𝑜𝑛 − €7.2 𝑚𝑖𝑙𝑙𝑖𝑜𝑛) × (100% − 57%) = €2.8 𝑚𝑖𝑙𝑙𝑖𝑜𝑛 × 43% = €1.2 𝑚𝑖𝑙𝑙𝑖𝑜𝑛

NOTE: If rights retained by the lessee are 57% then rights transferred to lessor will be (100% – 57% =) 43%.

Recording the transaction:

Let us finish by identifying the double entries necessary to record this transaction:

DR: Cash ➔ €10 million (sale proceeds)

DR: Right-of-use asset ➔ €4.1 million

CR: Property, plant and equipment ➔ €7.2 million (derecognise the underlying asset)

CR: Lease liability ➔ €5.7 million

CR: Seller’s gain ➔ €1.2 million (profit or loss account)

NOTE: The subsequent measurement of the right-of-use asset and the lease liability naturally follows the rules
laid down in the previous lectures/modules.
 FR - Accounting for transactions in financial
statements
After the Reporting Period – IAS10

The rules of IAS 10 apply for the period between the reporting date and the authorisation date. The financial
statements being authorised will not reflect any events which occur after this date.

Events after the reporting period are those events, both favourable and unfavourable, that occur between the
end of the reporting period and the date when the financial statements are authorised for issue.

IAS 10 identifies two types of such events:

1) Adjusting events. They are events after the reporting date that provide evidence of conditions that existed
at the end of the reporting period. Adjusting events include:
- The discovery of fraud or errors that already existed at the end of the reporting period;
- The settlement, after the reporting period, of a court case which confirms that the company had a present
obligation at the end of the reporting period;
- The receipt of information indicating that an asset was impaired at the end of the reporting period (e.g.
bankruptcy of a customer, sale of inventories at lower prices after the reporting period).

Treatment: The reporting entity must adjust the amounts recognised in its financial statements to reflect
adjusting events. However, it is not just the numbers that require adjusting but also the disclosures
contained in the notes.

2) Non-adjusting events. They are events after the reporting date that are indicative of conditions that arose
after the end of the reporting period. Non-adjusting events may include:
- Abnormally large changes in asset prices or foreign exchange rates;
- The destruction of a major production plant after the reporting period, for example by a fire;
- Announcing a major restructuring or a plan to discontinue an operation;
- A major business combination or disposing of a major subsidiary;
- Changes in tax rates or tax laws enacted or announced after the reporting period that have a significant
effect on current and deferred tax assets and liabilities.

Treatment: If non-adjusting events were discovered after the end of the reporting period are material and
non-disclosure could influence the economic decisions that users make on the basis of the company’s
financial statements, the company should disclose for each material category of non-adjusting event, the
following two pieces of information:
a) The nature of the event;
b) An estimate of its financial effect, or a statement that such an estimate cannot be made.

Special events:
1) If management determines after the reporting period that the going concern assumption is no longer
appropriate, then the financial statements should not be prepared on a going concern basis, but rather, on a
break-up basis. In this particular situation, the event is always adjusting;
2) If the company declares dividends to shareholders after the reporting period, those dividends cannot be
recognised as a liability as at the reporting date, i.e. the declaration of a dividend is never an adjusting
event.