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Module 9
CARD-MRI Development Institute, Inc.
Modular Learning
Page 2 of 20
Intermediate Accounting 1
Module Content || Prefinals
Lesson: Module 9-12
___________________________________________________________
Inventories
Learning Objectives:
Inventories
Recognition
Inventories are recognized when they meet the definition of inventory and they qualify for recognition as
assets, such as when legal title is obtained by the buyer from the seller.
In daily transactions, strict adherence to the passing of legal title is not practicable. However, proper
inventory cut-off procedures should be made prior to the preparation of financial statements for fair
presentation. Regardless of location, and entity shall report in its financial statements all inventories over
which it holds legal title to or has obtained control of the related economic benefits.
Goods in transit
Goods in transit pertain to goods already shipped by the seller but are not yet received by the
buyer. The lack of physical possession may pose a question on who owns the good in transit.
Depending on the terms of the sale contract, goods in transit may form part of the inventories of
either the buyer or seller, but not both. Such terms are either.
FOB shipping point- ownership over the goods is transferred upon shipment. Therefore, the
buyer records the purchase (and accounts payable) upon shipment.
FOB destination- ownership over the goods is transferred only when the buyer receives the
goods. Therefore, the goods in transit still form part of the seller’s inventories.
Sale contracts may also contain terms for shipping costs indicated by any of the following:
a. Freight collect- Freight is not yet paid upon shipment. The carrier collects shipping costs
from the buyer upon delivery. Thus, the buyer paid for the freight. However, this does not
mean that the buyer is the one who is supposed to pay for the freight.
b. Freight prepaid- The seller pays the freight in advance before shipment. However, this does
not mean that the seller is the one who is supposed to pay for the freight.
c. FAS (free alongside)- The seller assumes all expenses in delivering the goods to the dock
next to (alongside) the carrier on which the goods are to be shipped. The buyer assumes
loading and shipping costs. Title passes upon shipment to the carrier.
d. Ex-ship- The seller assumes all expenses until the goods are unloaded from the carrier, at
which time title passes to the buyer.
e. CIF (cost, insurance, and freight)- The buyer pays in lump sum the cost of the goods and
the insurance and freight costs.
f. CF (Cost and Freight)- The buyer pays in lump sum the cost of the goods and the freight
costs.
In either CIF or CF, the seller must deliver the goods to the carrier and pay the costs of
loading. Thus, title passes to the buyer upon delivery of the goods to the carrier.
The foregoing is meant only to define normal terms and usage. Actual contractual
arrangements between a buyer and a seller can vary widely.
As a rule, the entity who owns the good being shipped should pay for the shipping costs.
The pertinent entries in the books of ABC Co. under the different terms of purchase are as follows:
a. FOB shipping point, freight collect
Dec. 31,
20x1 Purchases 1,000.00
Accounts Payable 1,000.00
To record purchases on account
Jan. 2,
20x2 Freight-in 10.00
Cash 10.00
To record the payment of freight
to the carrier.
Jan. 5,
20x2 Accounts Payable 1,000.00
Cash 1,000.00
To record the settlement
of accounts payable
The buyer records the P 10 freight cost (as freight-in) because the buyer is the one who is supposed to
pay for the freight. Under FOB shipping point, the buyer owns the goods in transit. Therefore, the buyer
bears the cost of transportation. “Freight-in” is included as cost of the inventories purchased.
Dec. 31,
20x1
No Entry
Jan. 2,
20x2 Purchases 1,000.00
Accounts payable 1,000.00
To record purchases on account
Jan. 5,
20x2 Accounts Payable 1,000.00
Cash 1,000.00
To record the settlement
of accounts payable
The buyer does not record the P10 freight cost because the seller is the one who is supposed to pay for
the freight. Under FOB destination, the seller owns the goods in transit. Therefore, the seller bears the
cost of transportation.
Dec. 31,
20x1 Purchases 1,000.00
Freight-in 10.00
Accounts payable 1,010.00
To record purchases on account
and freight-in reimbursable to the seller
Jan. 2,
20x2 -
No entry -
Jan. 5,
20x2 Accounts Payable 1,010.00
Cash 1,010.00
To record the settlement of accounts payable
inclusive of reimbursement for freight
The buyer records the P 10 freight cost as “Freight-in’ because the buyer is the one who is supposed to
pay for the freight. However, since the seller already paid the freight (i.e, freight prepaid), the freight-in is
recorded as an increase in accounts payable. This is because the buyer shall reimburse the seller for the
freight.
Dec. 31,
20x1
No Entry
Jan. 2,
20x2 Purchases 1,000.00
Accounts payable 1,000.00
To record purchases on account
The buyer does not recognize freight-in for the freight he has paid because the seller is the one
who is supposed to pay for the shipping cost.
Consigned goods
Solution:
ABC Co. consigned goods costing P 10,000 to XYZ, Inc, Transportation costs of delivering the
goods to XYZ totaled P 2,000. Repair costs for goods damaged during transportation, totaled P
500. To induce XYZ Inc. in accepting the consigned goods, ABC Co. gave XYZ P 1,000
representing an advance commission. How much is the cost of the consigned goods?
a. Merchandise costing P 10,000, shipped FOB shipping point from a vendor on December 30,
20x1, was received and recorded on January 5, 20x2.
b. A package containing a product costing P 50,000 was standing in the shipping area when the
physical inventory was conducted. This was not included in the inventory because it was
marked “Hold for shipping instructions”. The sale order was dated December 17 but the
package was shipped and the customer was billed on January 3, 20x2.
c. Goods in the shipping area were included in inventory because shipment was not made until
January 4, 20x2. The goods, billed to the customer FOB shipping point on December 30,
20x1, had a cost of P 20,000.
d. Goods shipped FOB destination on December 27, 20x1 from a vendor to ABC Co. were
received on January 6, 20x2. The invoice cost of P 30,000 was recorded on December 30,
20x1 and included in the count as “goods in transit”.
Requirement: Determine the adjusted balances of (1) inventory and (2) accounts payable as of December
31, 20x1:
Solutions:
Inventory Accounts Payable
Unadjusted balances 160,000.00 100,000.00
a Purchase on FOB shipping point 10,000.00 10,000.00
b Unshipped goods not counted 50,000.00
c Unshipped goods counted -
d FOB destination improperly included (30,000.00) (30,000.00)
Adjusted balances 190,000.00 80,000.00
Inventories may be acquired or sold under various forms of financing agreements, which may include the
following:
a. Product financing agreement- a seller sells inventory to a buyer but assumes an obligation to
repurchase it at a later date. This arrangement does not result to the transfer of control over the
asset. Therefore, the seller retains ownership over the inventory.
b. Pledge of inventory- a borrower uses its inventory as collateral security for a loan. This
arrangement does not result to the transfer of control over the asset. Therefore, the borrower
retains ownership over the inventory.
c. Loan of inventory- an entity borrows inventory from another entity to be replaced with the same
kind of inventory. This arrangement results to transfer of control over the asset. Accordingly, the
borrower includes the loaned goods in the inventory.
purchases it. If not, he returns it to the seller. Under this type of arrangement, the legal title over the good
does not pass to the prospective customer until he approves it and purchases it.
Installment sale
An installment sale where the possession of the goods is transferred to the buyer but the seller retains
legal title solely to protect the collectability of the amount due is considered as a regular sale. Therefore,
the goods are excluded from the seller’s inventory and included in the buyer’s inventory at the point of
sale.
Lay-away sale
Is a type of sale in which goods are delivered only when the buyer makes the final payment in a series of
installments. This is different from a regular installment sale wherein goods are delivered to the buyer at
the time of sale.
The goods sold under a lay away sale are included in the seller’s inventory until the goods are
delivered to the buyer. Delivery is made after the final installment payment is paid. However, when
significant payments have already been made, the goods may be included in the buyer’s inventory,
provided delivery is probable.
Inventories are accounted for either through: (a)perpetual inventory system or (b) periodic inventory
system
Measurement
Inventories are measured at the lower of cost and net realizable value
Cost
The cost of inventories comprises the following:
a. Purchases cost- This includes the purchase price (net of trade discounts and other rebates),
import duties, non-refundable or non-recoverable purchase taxes, and transport, handling and
other costs directly attributable to the acquisition of inventory.
Purchase cost does not include refundable or recoverable taxes. For example, Value
Added Taxes (VAT) paid by VAT payers are not included as cost of inventory but rather
recognized as “Input VAT” and treated as reductions to VAT payments to the BIR.
Trade discounts, rebates, and other similar items are deducted in determining the
purchase cost.
Inventory 400
Cost of Sales 400
3. Received payment from customer for merchandise sold above (cash discount taken: P 10,000 sale- 500 return) x2% discount=
P 190:
Cash 9,310 Cash 9,310
Sales discounts 190 Sales discounts 190
Accounts Receivable 9,500 Accounts Receivable 9,500
4. Purchased on account merchandise for resale for P 6,000; terms were 2/10, n/30 (purchases record at invoice price):
7. Paid for merchandise purchased, refer to no. 4 (cash discount taken: P 6,000 purchase- 300 return) x 2%= P114
8. To transfer the beginning inventory balance to the Income Summary account (part of the closing entries under the periodic
inventory system)
1. Trade discounts
the amount deducted from the supplier's price list (SRP) to arrive at the invoice price (cost to the buyer).
NEVER JOURNALIZED
2. Cash discounts
To encourage prompt payments
ARE JOURNALIZED
Trade discount
Assuming that Bush Enterprise sold merchandise to Bin Company at a list price of P 100,000; trade discount- 25, 10;
2/10, n/30. The computation of the invoice price would be:
List Price P 100,000
Less: First trade discount (P 100,000 x 25%) 25,000
Balance net of first trade discount 75,000
Less: Second trade discount (P 75,000 x 10%) 7,500
Invoice price P 67,500
Conversion costs
As mentioned earlier, conversion costs refer to direct labor and manufacturing overhead costs,
which are necessary in converting raw materials into finished goods. On the other hand, prime costs refer
to the sum of direct materials and direct labor costs.
Manufacturing overhead are costs of production that are not directly traceable to the finished
goods but are necessary costs in producing the goods (e.g., depreciation on factory equipment, cost of
electricity to run a factory equipment, and the like). Manufacturing or production overhead are sub-
classified into (a) variable production overhead and (b) fixed production overhead.
Examples include Factory Power & Depreciation of Machinery (using the production-unit method).
Fixed overhead costs are constant and do not vary as a function of productive output, including
items like rent or a mortgage and fixed salaries of employees.
Absorption costing includes all of the direct costs associated with manufacturing a product, while variable
costing can exclude some direct fixed costs.
Absorption costing, also known as full costing, entails allocating fixed overhead costs across all units
produced for the period, resulting in a per-unit cost.
Variable costing includes all of the variable direct costs in COGS but excludes direct, fixed overhead
costs.
PAS 2 requires the use of absorption costing. Variable Costing is used only for internal purposes.
A production process may result in more than one product being produced simultaneously. This is the
case, for example, when joint products are produced (i.e., main product and a by-product)
When the conversion costs of each product are not separately identifiable, they are allocated
between the products on a rational and consistent basis. The allocation may be based, for example, on
the relative sales value of each product either at the stage in the productions process when the products
become separately identifiable, or at the completion of the production.
Cost formulas
1 FIFO- periodic
Unit Total
Units Cost Cost
Ending inventory to be allocated 4,000
Allocated as follows:
From Aug. 29 net purchases
(1,900 - 300) (1,600) 38.60 61,760.00
Bal. to be allocated to the next most 2,400
recent purchases date
From Aug. 21 purchase (2,400) 38.00 91,200.00
Ending inventory at cost 152,960.00
2 FIFO-perpetual
Date Transaction Units Unit cost Total Cost
Aug. 1Inventory 2,000 P 36.00 P 72,000.00
7 Purchase 3,000 37.20 111,600.00
12 Net Sales (4,200- 600) 3,600
Allocation:
from beg. Inventory (2,000) 36.00 (72,000.00)
from Aug. 7 purchase (1,600) 37.20 (59,520.00)
21 Purchase 4800 38.00 182,400.00
22 Sales 3800
Allocation:
from Aug. 7 purchase (1,400) 37.20 (52,080.00)
from Aug. 21 purchase (2,400) 38.00 (91,200.00)
29 Net Purchases (1,900-300) 1600 38.60 61,760.00
Ending Inventory at Cost P 152,960.00
3 Weighted Average-periodic
The weighted average unit cost is computed as follows:
1. Inventories are recognized when they meet the definition of inventory and they qualify for
recognition as assets, such as when legal title is obtained by the buyer from the seller.
2. An increase in inventory always has a corresponding increase in accounts payable.
3. If the beginning balance of inventory is P 50 while net purchases totaled P 100 and cost of goods
sold was P 30, the ending inventory must be P 120.
4. According to PAS 2 Inventories, inventories are measured at net realizable value.
5. Entity A’ s inventory had a cost of P 10 and NRV of P 8 on December 31, 20x1. Accordingly,
Entity A recognized an inventory write-down of P 2. On Dec. 31, 20x2, the cost of inventory
should be recognized at P 10.
ACTIVITY 1
1. On December 28, 20x1, Entity A purchases goods worth P 100,000 on account. Freight costs
amount to P 6,000. The seller ships the goods on December 30, 20x1. Entity A receives the
shipment on January 2, 20x2 and settles the account January 5, 20x2.
Requirements:
Compute for the cost of inventory on December 31, 20x1 and the net cash payment to the supplier on
January 5, 20x2 under each of the ff. scenarios:
2. Gross Company provided the following purchases and sales for the month of March:
Unit
Units Cost Required:
March 1 Beginning 1,000 270 Assuming the entity used perpetual system,
6 Purchase 3,000 250 compute ending inventory and cost of sales
14 Purchase 6,000 280 under:
25 Purchase 4,000 210 1. FIFO
March 9 Sale 2,000 2. Moving Average
31 Sale 8,000
Required:
Compute cost of inventory at current year-end.
Module 10
Inventory Estimation
Learning Objectives:
Introduction
There may be instances where the value of inventories must be estimated, such as when it is not
practicable to take a physical count. For example, in the interest of timeliness and cost consideration, an
entity may elect to rely on estimates of inventory at interim dates. Another instance is when records of
inventories are incomplete and inventories must be approximated.
PAS 2 permits the use of inventory estimates only when they reasonable approximate cost.
Generally, inventory estimation is made only for interim reporting. For annual reporting, physical count of
inventories on hand is more appropriate.
The cost of inventories may be estimated using either the (a) gross profit method or the (b) retail
method.
The gross profit method is a technique used to estimate the amount of ending inventory. The technique
could be used for monthly financial statements when a physical inventory is not feasible. (However, it is
no substitute for an annual physical inventory.) It is also used to estimate the amount of missing inventory
caused by theft, fire or other disaster.
Here's how the gross profit method works. First you must determine the gross profit percentage (gross
profit margin) that your company is currently experiencing. For example, if a retailer buys its merchandise
for P0.70 and sells the merchandise for P1.00, it has a gross profit of P0.30. The gross profit of P0.30
divided by the selling price of P1.00 means a gross profit margin of 30% of sales. This also means that
the retailer's cost of goods sold is 70% of sales.
Example:
The gross profit rates of an entity with sales of P 1,000 and cost of goods sols of P 800 are computed as
follows:
Cost ratio
Cost ratio may be derived from the gross profit rate. The following may provide guidance in deriving cost
ratios from gross profit rates.
Cost ratio from GPR based on sales = 100% Net sales – GPR based on sales
Cost ratio from GPR based on cost = 100% Cost of Goods Sold / Net sales (100% + GPR based
on cost)
Cost ratio from GPR based on sales = 100% Net sales – GPR based on sales
Cost ratio from GPR based on sales = 100% - 20%
Cost ratio from GPR based on sales = 80%
Net Sales
Net sales are total revenue, less the cost of sales returns, allowances, and discounts. This is the primary
sales figure reviewed by analysts when they examine the income statement of a business. The amount of
total revenues reported by a company on its income statement is usually the net sales figure, which
means that all forms of sales and related deductions are aggregated into a single line item.
On October 1, 20x1, a flood destroyed the warehouse of ABC Co. and all the inventories contained
therein. Off-site back-up data base shows the following information:
Additional information:
Goods in transit on October 1, 20x1 amounted to P 2,000 while goods out on consignment were P 1,200.
Damaged materials can be sold at a salvage value of P 500.
Solution:
Step 1: Compute for the net purchases using the accounts payable T-account.
Accounts Payable
6,000.00 beg. Bal.
47,000.00 Net Purchases (squeeze)
payments to
Suppliers 50,000.00
3,000.00 end. Bal.
Step 2: Extend the net purchases computed in Step 1 to the inventory T-account and squeeze for the
ending inventory.
Accounts Payable Inventory
6,000.00 Jan. 1 Jan. 1 14,500.00
47,000.00 Net Purchases (squeeze) Net Purchases47,000.00
payments to Freight-in 5,000.00
Suppliers 50,000.00 56,000.00 COGS
3,000.00 Sept. 30 Sept. 30 (squeeze) 10,500.00
Inventory
Jan. 1 14,500.00
Net Purchases 75,000.00
80,000.00 COGS
Sept. 30 (squeeze) 9,500.00
Cost Retail
Inventory, January 1 8,700 14,000
Purchases 55,300 80,300
Freight-in 2,000 -
Purchase discounts 500 -
Purchase returns 5,200 8,600
Departmental Transfers-In (Debit) 1,000 1,500
Departmental Transfers-Out (Credit) 800 1,200
Markups 6,000
Markup cancellations 2,000
Markdowns 12,000
Markdown cancellations 3,000
Abnormal spoilage (theft and casualty loss) 5,000 7,000
Sales 43,800
Sales returns 2,500
Sales discounts 1,000
Employee discounts 500
Normal spoilage 200
Requirement: Compute for (a) cost of goods sold and (b) ending inventory using the Average cost method
Solution:
Cost Retail
Inventory, January 1 8,700 14,000
Net purchases 51,600 71,700
Departmental transfers-in (debit) 1,000 1,500
Departmental transfers-out (credit) (800) (1,200)
Net markups (6,000-2,000) 4,000
Net markdowns (12,000-3,000) (9,000)
Abnormal spoilage (5,000) (7,000)
Total goods available for sale 55,500 74,000
Net sales (42,000)
Ending inventory at retail 32,000
Quiz 2
QUIZ 2
a. If the gross profit rate based on sales is 36%, the gross profit rate based on cost is 26.47%.
b. If the gross profit rate based on cost is 40%, the gross profit rate based on sales is 28.57%.
c. If the gross profit rate based on sales is 25%, the cost ratio is 75%.
d. If the gross profit rate based on cost is 40%, the cost ratio is 62.46%.
e. During the year, an entity had net purchases of P 100. If inventories increased by P 20 at the end
of the year, the cost of goods sold must be P 120.
Problem 2:
1. The following data relate to the records of Powell Corp. for the month of September:
Sales P 160,000
Requirements: Using these data, estimate the cost of ending inventory for each situation below:
Problem 3:
Retail Method
Gibb’s Department Store uses the retail inventory method. Information relating to the computation
of the inventory at December 31, 20x2 is as follows:
Cost Retail
Freight-in 6,750
Markups 50,000
Markdowns 20,000
Estimated normal Shrinkage 2% of sales
Requirements: Compute for (1) ending inventory and (2) cost of goods sold using average cost method.
Activity 2
1. On May 17, it was discovered that a material amount of inventory had been stolen. A physical
count discloses that P 55,000 of merchandise was on hand as of May 17. The following additional
data is available from the accounting records:
Records indicate that the company’s gross profit has averaged 40% of selling prices.
Module 11
Investments
Learning Objectives:
Financial Instruments
Financial instrument- is “any contract that gives rise to a financial asset of one entity and a financial
liability or equity instrument of another entity.”
Equity instrument- is “any contract that evidences a residual interest in the assets of an entity after
deducting all of its liabilities.
Equity instrument-evidences a residual interest in the net assets of an entity, e.g. shares of stocks
Equity securities- equity instruments that are classifiable as investments, e.g. Investment in shares of
stocks
Debt instrument- represents debtor-creditor relationship (lending transaction), e.g., receivables, payables
and bonds
Debt securities- debt instruments that are classifiable as investments, e.g. investment in bonds
Examples of financial liabilities are: trade payables, loans from other entities, and debt instruments issued
by the entity.
Requirement: Determine the financial assets to be disclosed in the notes to the financial statements
Solution:
Cash and cash equivalents 13,000
Accounts receivable 15,000
Allowance for bad debts (2,000)
Note receivable 5,000
Interest receivable 2,000
Investment in associate 20,000
Investment in subsidiary 55,000
Invesment in equity instruments 13,000
Cash surrender value 12,000
Sinking Fund 20,000
Investment in bonds 12,000
Total financial assets 165,000
The following are taken from the records of ABC Co. as of year-end.
Accounts payable 2,000 SSS contributions payable 6,000
Utilities payable 7,000 Cash dividends payable 4,000
Advances from customer 1,000 Property dividends payable 7,000
Accrued interest expense 6,000 Stock dividends payable 3,000
Unearned rent 9,000 Lease Liability 35,000
Warranty obligations 5,000 Bonds payable 120,000
Unearned interest on receivables 3,000 Discount on bonds payable (15,000)
Income taxes payable 2,000 Security Deposit 2,000
Solution:
Initial recognition
Financial assets are recognized only when the entity becomes a party to the contractual provisions of the
instrument.
a. Amortized cost;
b. Fair value through other comprehensive income (FVOCI); or
a. The entity’s business model for managing the financial assets; and
b. The contractual cash flow characteristics of the financial asset.
Classification at Amortized Cost
A financial asset is measured at amortized cost if both of the following conditions are met:
a. The asset is held within a business model whose objective is to hold financial assets in order to
collect contractual cash flows (Hold to collect business model); and
b. The contractual terms of the financial asset give rise on specified dates to cash flows that are
solely payments of principal and interest on the principal amount outstanding.
A financial asset is measured at Fair Value through Other Comprehensive Income if both of the following
conditions are met:
a. The financial asset is held within a business model whose objective is achieved by both collecting
contractual cash flows and selling financial assets (Hold to collect and sell business model) and
b. The contractual terms of the financial asset give rise on specified dates to cash flows that are
solely payments of principal and interest on the principal amount outstanding (SPPI)
A financial asset that does not meet the conditions for measurement at amortized cost or FVOCI is
measured at fair value through profit or loss (FVPL). This is normally the case for held for trading
securities.
A business model refers to how an entity manages its financial assets in order to generate cash flows. It
is determined at a level that reflects how groups of financial assets are managed rather than at an
instrument level. IFRS 9 identifies three types of business models: ‘hold to collect’, ‘hold to collect and
sell’ and ‘other’. Many entities may only have one business model but it is possible to have more than
one.
In order to determine which type of business model(s) an entity has, it is necessary to understand the
objectives of each business model and the activities undertaken. In doing so, an entity would need to
consider all relevant information including, for example, how business performance is reported to the
entity’s key management personnel and how managers of the business are compensated.
Hold to collect
The objective of the ‘hold to collect’ business model is to hold financial assets to collect their contractual
cash flows, rather than with a view to selling the assets to generate cash flows. However, there is no
requirement that financial assets are always held until their maturity, and IFRS 9 identifies some sales
that are considered consistent with the ‘hold to collect’ business model irrespective of their frequency and
significance. This is in contrast to the held to maturity category under IAS 39 which penalized entities for
sales in all but exceptional circumstances (commonly known as ‘tainting rules’). Nevertheless, it is
expected that sales would be incidental to this business model and consequently an entity will need to
assess the nature, frequency and significance of any sales occurring.
Only financial assets that meet the SPPI test and are held in a ‘hold to collect’ business model can be
classified at amortized cost. A typical example would be trade receivables or intercompany loans where
the entity intends to collect the contractual cash flows and has no intention of selling those financial
assets.
Hold to collect and sell
Under the 'hold to collect and sell’ business model, the objective is to both collect the contractual cash
flows and sell the financial asset. In contrast to the ‘hold to collect’ business model, sales are integral
rather than incidental, and consequently this business model typically involves a greater frequency and
volume of sales.
Only financial assets that meet the SPPI test and are held in a ‘hold to collect and sell’ business model
can be classified at fair value through other comprehensive income for debt. One example would be
government or corporate bonds that are held with the dual objective of holding those bonds to earn
interest and selling those bonds before their maturity in order to generate cash for investment or liquidity
purposes.
It is worth noting that this business model could also apply to trade receivables in cases where an entity
has a practice of factoring subsequent to initial recognition. In these cases, further analysis would be
required in order to determine whether the factoring arrangement constitutes a sale and if so whether a
‘hold to collect and sell’ business model or indeed one of the ‘other’ business models is more appropriate.
Other
Other business models are all those that do not meet the ‘hold to collect’ or ‘hold to collect and sell’
qualifying criteria. Some examples are:
business models for which the primary objective is realizing cash flows through sale (i.e.
collecting contractual cash flows is incidental)
business models which are managed and performance evaluated on a fair value basis
All non-equity financial assets falling into ‘other’ business models must be classified at fair value through
profit or loss, irrespective of whether the SPPI test is passed.
Notes:
Only debt instruments can be classified under the amortized cost or FVOCI (mandatory)
measurement categories
Equity instruments are measured at FVPL, unless the entity makes an irrevocable election on
initial recognition to measure them at FVOCI (election)
Debt instruments that are not measured at amortized cost or at FVOCI are measured at FVPL.
Initial Measurement
Financial assets are initially measured at fair value plus transaction costs, except FVPL.
Financial assets classified as FVPL are initially measured at fair value. The transaction costs are
expensed immediately.
Fair value is defined as “the price that would be received to sell an asset or paid to transfer a liability in an
orderly transaction between market participants at the measurement date (i.e. an exit price)”.
IFRS 13 indicates that an entity must determine the following to arrive at an appropriate measure of fair
value: (i) the asset or liability being measured (consistent with its unit of account); (ii) the principal (or
most advantageous) market in which an orderly transaction would take place for the asset or liability; (iii)
for a non-financial asset, the highest and best use of the asset and whether the asset is used in
combination with other assets or on a stand-alone basis. (iv) the appropriate valuation technique(s) for the
entity to use when measuring fair value, focusing on inputs a market participant would use when pricing
the asset or liability; and (v) those assumptions a market participant would use when pricing the asset or
liability.
IFRS 13 requires that the fair value of a liability or equity instrument of the entity be determined under the
assumption that the instrument would be transferred on the measurement date, but would remain
outstanding (i.e., it is a transfer value not an extinguishment or settlement cost.). Accordingly, the fair
value of a liability must take account of non-performance risk, including the entity’s own credit risk
Offsetting positions
The new Standard allows a limited exception to the basic fair value measurement principles for a
reporting entity that holds a group of financial assets and financial liabilities with offsetting positions in
particular market risks as defined in IFRS 7, Financial Instruments: Disclosures, or counterparty credit risk
(also as defined in IFRS 7) and manages those holdings on the basis of the entity’s net exposure to either
risk. The exception allows the reporting entity, if certain criteria are met, to measure the fair value of the
net asset or liability position in a manner consistent with how market participants would price the net risk
position.
Valuation techniques
When transactions are directly observable in a market, the determination of fair value can be relatively
straightforward, but when they are not, a valuation technique is used. IFRS 13 describes three valuation
techniques that an entity might use to determiner fair value, as follows: (i) the market approach. An entity
uses “prices and other relevant information generated by market transactions involving identical or
comparable (i.e. similar) assets, liabilities or a group of assets and liabilities”; (ii) the income approach. An
entity converts future amounts (e.g., cash flows or income and expenses) to a single current (i.e.,
discounted) amount; and (iii) the cost approach.
IFRS 13 requires that a valuation technique should be selected, and consistently applied, to maximize the
use of relevant observable inputs (and minimize unobservable inputs).
IFRS 13 permits a premium or discount to be included in a fair value measurement only when it is
consistent with the unit of account for the item. This means that premiums or discounts that reflect size as
a characteristic of the entity’s holding (e.g. a blockage factor reducing the price which could be achieved
on disposal of an entire large equity holding) rather than as a characteristic of the asset or liability (e.g. a
control premium when measuring the fair value of a controlling interest) are not included.
Disclosures
IFRS 13 requires a number of quantitative and qualitative disclosures about fair value measurements.
Many of these are related to the following three-level fair value hierarchy on the basis of the inputs to the
valuation technique: Level 1 inputs are fully observable (e.g. unadjusted quoted prices in an active market
for identical assets and liabilities that the entity can access at the measurement date); Level 2 inputs are
those other than quoted prices within Level 1 that are directly or indirectly observable; and Level 3 inputs
are unobservable.
An asset or liability is included in its entirety in one of the three levels on the basis of the lowest-level input
that is significant to its valuation.
The market
Fair value measurement requires assumptions based on current market conditions. It assumes that the
transaction to sell the asset or transfer the liability takes place either:
The most advantageous market is the one, which maximizes the amount that would be received for the
asset or paid to extinguish the liability after transport and transaction costs. Often these markets would be
the same.
The price
The market price used in measuring fair value is not adjusted for any transaction costs but is adjusted for
any transport costs.
1. ABC Co. holds an asset that is required by PFRSs to be measured at fair value. The following
information relates to the asset as of the end of the current reporting period.:
Case #1 – The principal market for the asset is Active market # 2. How much is the fair value
measurement for the asset?
Case #2 – Neither market is the principal market for the asset. How much is the fair value
measurement for the asset?
ACTIVITY 3
Timeline!
References